I love the Roth IRA.
In simplest terms, you will get to keep a lot more of the money that you saved in a Roth IRA than in other types of retirement accounts. That’s because Roth IRA’s grow tax-free, meaning you don’t have to pay income taxes on your distributions in retirement.
But what if you are just now discovering the benefits of a Roth IRA? If you are young and just starting out, great—open a Roth today! But what if you have been saving for years in something other than a Roth—let’s say, a 401(k) or a Traditional IRA? Chances are, all this money you’ve accumulated will all be taxable in retirement (meaning you can plan on setting aside a chunk of it for the IRS…).
Roth Conversion defined
But wait—there’s good news! You can take that pre-tax money you have saved in your Traditional IRA or old 401(k) and transfer it into a Roth IRA! This is called a Roth Conversion. You are converting money from a pre-tax retirement account into an after-tax retirement account. Now, all that money in your new Roth IRA will start growing tax-free!
Of course, you should read the fine print. Since you have not paid income tax on your pre-tax retirement account balances, you need to pay income taxes on the amount that you convert. Let’s say you convert $50,000 to a Roth IRA this year. This means you will report $50,000 on your taxes next Spring and will owe income taxes on that amount.
With that in mind, does it even make sense? Surprisingly, yes! For many people, a Roth conversion can be hugely beneficial. Here are practical examples of people who could utilize a Roth conversion:
The Young Career Changer
If you are early in your career, chances are you will have several pre-tax retirement accounts from different employers. Mathematically, a Roth conversion of these old accounts will probably make sense due to the time value of money. Money invested for 20, 30, or 40 years can have the opportunity to grow exponentially if invested properly. Paying taxes now on a relatively smaller amount will trump paying taxes later on a much larger amount.
The Partial Conversion Professional
Think you already pay enough taxes? Consider converting small amounts every year. Filling up your income tax bracket each year with a Roth conversion might make sense over the long run. For example, if you are in the 15% tax bracket, convert just enough so that you “fill up” the 15% bracket without flowing over into the 25% bracket. This way you aren’t breaking the bank to cover your increased taxes.
The Pre-Retiree Planner
If you are nearing retirement, you can optimize your retirement income by utilizing a Roth conversion. Will you have a year (or years) when income is lower? Perhaps you or your spouse will be retiring before the other, or maybe you are cutting back and working part-time. Take advantage of one of these “down years” by converting some of your pre-tax money to a Roth. The taxes owed on the conversion will be lower since you converted strategically in a year when your income was lower.
The RMD and Inheritance Enhancer
If you are a retiree with lots of pre-tax retirement dollars, a Roth conversion can bypass the damaging effects of Required Minimum Distributions (RMD’s). RMD’s will slowly, then rapidly, erode your pre-tax accounts. Roth IRA’s, on the other hand, aren’t required to be liquidated after age 70 ½! Or, if your beneficiaries are all set to inherit large amounts of pre-tax retirement accounts, do them an additional favor by considering a Roth conversion. This will mean they can keep more of their annual withdrawals from their inherited IRA.
So why don’t more people do Roth conversions? For starters, paying more taxes today is a tough pill to swallow. But making hard choices today can mean saving thousands of dollars in the future. Secondly, a lot of people’s situations cannot be solved by an online “Roth Conversion Calculator.” Frankly, these calculators are simple tools that don’t consider every factor.
Does it make sense for you? Let’s find out! Start the conversation with us below so that we can help answer this question with you.
Jake is a co-founder and Director of Investing at Stewardship Financial. In his role he gets to help people make smarter decisions on how to invest in the capital markets.