We know that taxes are one of life’s two inevitable. So, the question is not if you will pay taxes on your retirement accounts, but when and how much. That’s where Roth IRAs enter the discussion, especially in the current tax and market environment.
With a traditional IRA, pre-tax dollar contributions grow tax-deferred. The benefit for most people is that after you retire and start taking money out of your IRA, you may be in a lower tax bracket.
A Roth IRA, on the other hand, is funded with after-tax dollars, meaning you’ve already paid income tax on your contributions, so your withdrawals after 59½ are tax-free (if the account has been open for at least five calendar years).
It’s important to know this distinction when setting up an IRA and make the proper choice for the long term. Most of us, however, never had the choice of a Roth and have been funding traditional IRAs for decades.
But the federal government did investors a favor in 2010 and began allowing conversions from traditional to Roth IRAs, without income limits. The conversion to a Roth can be from a traditional IRA, simplified employee pension (SEP) IRA, or savings incentive match for employees (SIMPLE) IRA.
Remember, this article is for informational purposes only, not a replacement for real-life advice. A tax professional should be consulted before attempting this type of strategy. Tax rules are constantly changing, and there is no guarantee that the tax treatment of Roth or Traditional IRAs will remain the same as it is now.
Also, Roth conversions have come under much scrutiny during the past few years. Congress has considered legislation that would prevent high-income Americans from Roth conversions. While no action has taken place, it is possible that Roth rules may change in the future.
Benefits of Converting to a Roth
Converting your traditional IRA to a Roth may make sense if you anticipate that tax rates will increase in the future or that your personal circumstances could put you in a higher tax bracket upon retirement because Roth withdrawals are tax-free.
Moving to a Roth IRA also means that you won’t have to take required minimum distributions (RMDs) on your account when you reach age 72. Under current IRS rules, if you are the original owner of a Roth IRA, you never have to make mandatory withdrawals from your account. This is important for estate purposes since it may leave more money in your account, growing tax-free, to pass on to your heirs.
Keep in mind that under the 2019 SECURE Act, most non-spouse beneficiaries of a Roth IRA are required to have the funds distributed to them by the end of the tenth calendar year following the year of the original owner’s death.
Downside of a Roth Conversion
The downside is the money moved to a Roth is taxable when it’s converted. The converted amount shows up as income on that year’s tax return. That extra reported income could have consequences for your tax bracket. Many investors adopt a partial conversion strategy, to keep the reportable income smaller.
Also, if you’re close to retirement, it may not make sense to convert because you can project your retirement income more accurately since taxes won't be a consideration for this account.
Paying the Taxes
The effectiveness and advisability of a Roth conversion depend on your funding sources for paying the up-front taxes. If you don’t have the savings available elsewhere to pay the taxes, a conversion may not make sense. Taking out a loan to pay the taxes may not be the best move in a rising-rate environment. And using money from the retirement investment you are converting will mean you forfeit the potential growth of those assets for years to come.
What To Do?
Choosing to convert to a Roth is not a simple decision. While now may be the best time in years to make the move because your investments may have lost value during the prolonged down market.
As your trusted financial professional, I’m here to help you weigh the pros and cons of a move like this and give you guidance to ensure any decisions are consistent with your long-term financial goals.