5 reasons to consider a Roth conversion

5 reasons to consider a Roth conversion

In March, Matt wrote about 10 smart financial moves to make during uncertain times. One of those savvy strategies? Consider a Roth conversion. Why? In several circumstances, Roth IRA conversions can save you and/or your heirs a lot in taxes. We wanted to spend some more time this month explaining when a taxable transfer from a pre-tax retirement savings account to a Roth IRA makes sense. 

This is one of those in-the-weeds topics that can get technical quickly. Many people don’t know Roth Conversions are possible, let alone what their advantages are! There are also some red flags to watch out for when employing this strategy, so make sure you get advice from a qualified financial planner before jumping in. 

The basics: Retirement savings accounts and taxes

There are two different types of retirement savings accounts: 

  • Pre-tax accounts like traditional IRAs or 401(k)s: You aren’t taxed on the money you put into the account. (Either because savings are taken out of your paycheck before taxes are calculated or, if you are self-employed, you deduct your contributions when filing your taxes.) Saving reduces your overall income, which lowers your current tax bill. You are taxed when you take money out of this account in the future. In short: Tax break now. Pay taxes in retirement. 
  • Tax-free Roth IRAs or 401(k)s: These retirement accounts don’t impact your taxes when you contribute to them. You can’t deduct your contributions or use them to lower your overall income. But when you remove money from the account during retirement, it’s tax free. Unlike Roth 401(k) contributions, Roth IRAs have both income limits that are updated annually by the IRS. (In 2022, for example, married couples filing jointly who make more than $214,000 or single filers making more than $144,000 can’t contribute directly to a Roth IRA.1) There are no annual required minimum distributions (RMDs) on Roth IRAs in retirement. In short: Pay taxes now. No taxes later. 

How does a Roth conversion work? 

A Roth conversion is when you move money from a Pre-tax IRA over to a Roth IRA. This triggers income tax when you do it, but allows that money to grow tax-free in the Roth going forward.

In 2022, there are currently no income limits for Roth conversions. People at all income levels can convert traditional IRAs or 401Ks to Roth IRAs. There are also no limits to how much you can convert—but you’ll have to pay taxes on the total, just like you would on any other ordinary income.

Your wealth advisor can help you complete the conversion. Although there are different methods, it’s best to do a direct transfer at your custodian. 

Five reasons to consider a Roth conversion

When does it make sense to trade taking a tax hit now for tax-free withdrawals in the future? Here are six examples of when a Roth conversion is to your (big!) advantage: 

  1. You’re on track for a big tax refund this year. Let’s say you’re expecting to get a $10,000 tax refund this year. But you’ve planned and budgeted well, and you don’t need that money right away. If you are in the 24% tax bracket, a $40,000 Roth conversion would let your $10,000 refund to pay the tax the conversion will generate—without causing any tax pain. Congrats: You have $40,000 tax-free dollars coming to you in retirement…plus the investment earnings the Roth IRA generates in the future. 
  1. The market has dropped significantly. This is the scenario we talked about in an earlier blog post. For ease-of-math purposes, let’s say your $10,000 pre-tax retirement fund lost 50% of its value in a steep market drop. You expect the market to rise again over time. You can convert that $5,000 investment into a Roth IRA, paying far fewer taxes than you would have at full value, and then let the investment grow back again. Congrats: The income from your (fingers crossed) quickly rebounding Roth IRA  will be yours tax-free in the future. 
  1. You want to take advantage of your currently low tax bracket. This often happens shortly after retirement before Social Security and RMDs begin. You are making zero income, but living your best life in a 10% or 12% tax bracket. Using this strategy, you would convert enough to “fill up” the relatively low tax bracket without jumping up to the next one (currently 22% at $83,550 for married joint filers). Congrats: You’ve secured future tax-free income for yourself at your bargain-basement tax rate!
  1. You are staring down a big future tax bill. If you have built up quite a bit of savings in traditional IRAs (good job!), the required minimum distributions that kick in at age 72 may bump you up into a higher tax bracket. Instead, strategically convert some of your traditional IRAs into Roths now. Congrats: You’ve lowered your future self’s tax bill by thousands of dollars.

    Sadly, spouses should also consider the tax implications of losing a partner in retirement. Tax brackets for single filers are steeper than for couples, and a surviving spouse often ends up paying higher tax on the same assets & income the couple enjoyed. Converting some retirement assets to tax-free Roth IRAs can protect mourning spouses from being hit with additional tax bills while they are grieving.
  2. You want to give your heirs a tax-free inheritance. Taxes on traditional IRA inheritances can be steep, especially because most non-spouse recipients are required to withdraw all funds—and pay taxes on them—within 10 years. Converting some or all of retirement accounts you expect to be used by others into Roth IRAs can free them from a complicated tax burden. Congrats: You’ve given your heirs a beautiful, tax-free gift.

What to look out for in a Roth conversion

As in most smart tax strategies, Roth conversions can get tricky. Make sure you run the numbers with your financial planner before converting. In particular, watch out for these three questions: 

  1. Will my Roth conversion push me into a higher Medicare premium bracket? If so, do my tax savings outweigh the higher premiums? 
  2. Will my Roth conversion cause my Social Security benefits to be taxed (or raise that tax rate)?
  3. Will “income” from my Roth conversion raise my state tax bill enough to cancel out the federal tax benefits ?

Any of the five scenarios sound like you? Make an appointment with one of our flat-fee-only wealth advisors to discuss whether Roth conversions are right for you. 
1. “Amount of Roth IRA contributions that you can make for 2022,irs.gov. Accessed 9 June 2022.

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