Are you considering a Roth IRA conversion or just want to learn more about what it is? Then you are in the right place. In this blog, I will take you through the benefits to each type of account, when to convert, and what you will gain or give up by doing so. Feel free to skim through the blog’s bold topics to find the info that pertains to you.
In a nutshell
A Roth Conversion is when you move money from a pretax retirement account such as an IRA or 401(k), into a Roth account. The main consideration for doing this, is tax savings. If a conversion will result in paying less tax, you should almost always convert your Traditional IRA or 401(k) into a Roth.
Retirement Planning Course (on Zoom)
My associate, Marta Amaton, and I are teaching the Four Pillars of a Successful Retirement Educational Course offered through the Napa Valley College. This course will take a deep dive into Roth Conversions and other topics such as: Maximizing social security, generating retirement income, navigating taxes in retirement, and legacy planning. If you are interested, [click here], or visit our “Events” tab to get more information.
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What is a Roth and how does it work?
In order to understand a Roth conversion, it is important to first understand the differences between a Traditional IRA, Roth IRA, 401(k), and Roth 401(k). Simply put, anything with “401(k)” in the name is an employer sponsored plan that is only available through an employer. An IRA stands for an Individual Retirement Account and is therefore done at the individual level. You can either invest independently or through a financial advisor. Both IRAs and 401(k)’s have tax benefits, but they differ when it comes to contribution limits and rules. For simplicity and the purpose of this blog, think of a 401(k) as being the employer sponsored version of a Traditional IRA, and a Roth 401(k) as the employer sponsored version of a Roth IRA.
A Traditional IRA and 401(k) are both funded by your pretax contributions. This means that the contributions reduce your taxable income (Income limits apply). When you begin withdrawing money from a Traditional IRA or 401(k) in retirement, the money is completely taxable. This applies to your contributions, capital gains, interest, and dividends. The idea is that you are betting on your taxable income going down in retirement, which could put you in a lower tax bracket. Therefore, you could potentially end up paying less in taxes when you begin taking distributions. Speaking of distributions, for both Traditional IRAs and 401(k)’s, you must begin taking Required Minimum Distributions (RMDs) from your account by age 72 [401(k) is exempt from RMDs if you continue working]. Similar rules also apply for SEP IRA’s.
On the other hand, a Roth IRA and Roth 401(k) are both funded with after-tax dollars (think – money in your bank account), while the qualified distributions are completely tax and penalty free. A qualified distribution is one that is made after age 59 ½ and 5 years since your first contribution was made. Therefore, if done properly, your capital gains, interest, and dividends would all completely tax free. Also, there are no RMDs for Roth accounts, meaning that you can grow your money tax free without ever touching it during your lifetime.
When does it make sense to do a Roth Conversion?
You would want to do a Roth conversion if the tax savings from converting, outweigh the tax savings on your Traditional IRA/401(k). Typically, this begins to take effect if you have over 5 years until the funds are needed. The benefits of a conversion become amplified the longer you can stretch that time. If you are planning on doing a Roth conversion, it becomes especially appealing during bad times in the stock market. Reason being that if your investments go down in value, you will have a lower tax liability upon conversion. Finally, if you are close to reaching the next tax bracket, it is best to wait until you have a clear idea of your taxable income for the year. This will give you the best insight as to whether the conversion will push you into a higher marginal tax bracket. For those covered under Medicare, it is vital to pay attention to the IRMAA brackets to determine if a conversion will push you into paying higher monthly Medicare Part B and D rates.
Disadvantages of a Roth conversion.
Converting to a Roth will increase your taxable income and the overall taxes you pay for the year. If your income is close to reaching the next marginal tax bracket, the distribution may put you over the threshold. This risk can be mitigated by doing the conversion over time. It is also important to note that once a Roth conversion is done, it cannot be reversed.
Bottom Line
Roth accounts are powerful wealth building tools that have become increasingly popular since the early 2000’s. In many cases, they are a much more tax efficient than traditional IRAs or 401(k)’s. That being said, every person’s situation is unique and should be considered before making a conversion. Please reach out to me personally if you would like to discuss your personal situation to see if a Roth conversion is right for you.
Direct: (707) 681-7043
Email: remy@jacobsonwealth.com
If you are interested in learning more about these types of topics, please [CLICK HERE] or visit the Four Pillars of a Successful Retirement educational course offering in our “Events” tab.
Material discussed is meant to provide general information and it is not to be construed as specific investment, tax or legal advice, nor should it be considered a recommendation to take a particular course of action. United Planners and its representatives do not provide tax or legal advice.