Are you considering whether converting an IRA to a Roth makes sense for your retirement? To help determine if this strategy makes sense, we have provided the basics of how it works and when it could fit into your finances below.
Employer-sponsored retirement plans (401k)
Employer-sponsored retirement plans, primarily the 401(k), are the predominant vehicle that the majority of Americans utilize to save for their retirement. You can avoid paying taxes on the money that is placed into the accounts while you are working. The idea is that once retired, you will be in a lower tax bracket and therefore, would be paying a lower income tax rate on distributions from your 401(k) or IRA.
However, there are scenarios where this may not play out to the disappointment of many and their savings. Let’s examine how a few situations may push an individual into a higher tax bracket in retirement.
- The 2017 Tax Cuts and Jobs Act (TCJA) is currently scheduled to sunset at the end of 2025. This legislation reduced rates and brackets for millions of Americans. Unless Congress decides to act, these rate cuts will be temporary. Depending on politics and which party has control in Congress will have a tremendous amount of influence on whether tax rates will return or climb past pre-TCJA levels.
- For individuals with IRAs, 401(k), or any other qualified plan, you are required to start taking distributions from your account. Once you turn 72, you are mandated to begin taking a percent of your tax-deferred account. Depending on the size of your account, these required minimum distributions (RMD) could push you into a higher tax bracket.
- Finally, in accordance with the adage ‘death and taxes’, many Americans face the hard reality that after their spouse passes, they are now categorized in the tax bracket for singles. If the deceased had an IRA as well, the required minimum distributions would still apply. Now the income that was taxed at the joint rates is being taxed now at the single-payer rates and could increase the tax liability significantly.
For these reasons, it may give you pause before utilizing a Roth conversion. We will now analyze various reasons why a Roth conversion may be worth considering and what individuals should digest before making a decision.
The first step is to determine your taxable income. Once you can calculate this, you will then be able to find your top income bracket. This illustrates how much in taxes you will pay any additional dollar that is considered income. You will also be able to learn how much room you have until the next bracket. It is key that you do not convert too much of your account at once as it may push you into a higher tax bracket. It is also important to know where you will be funding the additional tax liability from. Should you need to pull additional money from your IRA, you will also incur a 10% penalty, should you be younger than the year you turn 59 ½.
Although there are several considerations and potential reasons that a Roth conversion may not be the best strategy in every case, there are several advantages that individuals point to as their driving factor in utilizing a Roth conversion.
Advantages of a Roth Conversion
- Diversification: When the majority of people hear ‘diversification’, they point to the various asset classes such as stocks and bonds. However, diversifying the taxation of your money allows for more flexibility in retirement and having more control over how much one will have to pay in taxes.
- Tax-free growth: Because Roth contributions or conversions require the monies to be after-tax, it means the growth of the account is all tax-free. In theory, you’re paying taxes on a smaller amount and with account growth, you will end up paying less in taxes on the account than if it was all tax-deferred.
- Control: Since Roths are after-tax dollars, the IRS does not require you to take minimum distributions when you turn 72. One can leave the assets inside the account and continue to grow tax-free. This strategy makes sense when considering passing tax-free assets to heirs.
Since taxes have been paid on the monies invested in the account, and the account grows tax-free, the income that is generated from the account comes out tax-free to individuals. As long as you’ve had the account for five years and over 59 ½, all distributions from the account come to the individual on a tax-free basis.
As you can see, a Roth conversion certainly has plenty of reasons as to when and why it should be a strategy worth considering. It may not always be a straightforward answer, but working with a financial professional to analyze the suitability of the approach could help bring clarity to the decision-making process.