A ROTH Conversion is a tax planning strategy that shifts money from a pretax retirement account to an after-tax retirement account. This is a popular strategy for many reasons, so we are going over some details for you. Although it is not the perfect fit for every investor, it remains one of our favorite long-term planning strategies.
First, a ROTH IRA is similar to a Traditional IRA but has one significant difference. A ROTH is funded with after-tax dollars, and all qualified distributions can be tax-free. When planning for the future, there are many reasons why tax-free retirement money is appealing. We will get to the benefits in a minute; here is the process of a ROTH Conversion.
What accounts are eligible to convert to a ROTH:
- Traditional IRA
- Simple IRA
- SEP IRA
- 401K
In the above-listed accounts, you are funding them with pretax dollars. In most cases, you will receive a tax deduction for the year you contribute to the retirement account. Withdrawals from these accounts after 59 1/2 will be taxed as income. Early withdrawals can incur a 10% penalty, and the required minimum distributions “RMD” must start at age 72.
How do you convert money to a ROTH:
You elect how much money you wish to transfer to your ROTH IRA and can either transfer securities in kind or cash from your account. The amount converted to your ROTH will go down as income for the year you complete the conversion. There is no limit to how many ROTH Conversions you can do in a year or how many years you can do this for.
Is my money now tax-free?
Once the money or securities are in your ROTH IRA, they can be tax-free if you take a qualified distribution. A qualified distribution from a ROTH IRA occurs after 59 1/2. All money converted into a ROTH must remain in the account for five years to be considered qualified.
* There are other times you can avoid the 10% early withdrawal penalty. Like other retirement accounts, situations like a first-time home purchase, disability, paying for higher education, etc. can allow you to withdraw money and avoid the 10% penalty.
Here are a few reasons to convert to a ROTH:
- You can have better control of your income in retirement. Unlike a traditional pretax IRA or 401K, a ROTH does not have a required minimum distribution date. Money in a traditional IRA needs to start being withdrawn when you reach age 72. This can give you a lot more taxable income that you may not need for the year. You can end up paying a significant income tax bill, and because you don’t need this money to live, turn around and re-invest it. If your money were in a ROTH, you would avoid the tax as your money can stay invested.
- This also impacts a retiree living on a tighter budget or with a smaller nest egg to draw on. Chances are, this person would need all the money they can access in retirement. Being able to withdraw money from a ROTH will give them tax-free money and can make a big difference in their ability to live comfortably.
- If you anticipate you will be in a higher tax bracket in the future, then doing a ROTH conversion is also beneficial. A lower tax bracket leads to less paid taxes. Also, if you believe your account will grow over time based on your investments, then you will be paying taxes on a smaller dollar amount now on top of paying at a lower tax bracket.
- You want to leave the largest inheritance possible to your heirs: It’s simple… Pay the taxes now and let your money stay invested compounding until you die, in which they will inherit a tax-free account.
- Your income doesn’t allow you to qualify for a ROTH IRA: To be eligible to contribute to a ROTH IRA, you must meet specific income guidelines. You can do a backdoor ROTH conversion if you earn too much money making you ineligible for a ROTH IRA. You can contribute to a Traditional IRA (deductible or non-deductible) and simultaneously move that contribution to your ROTH. This is a way for higher earners to build up a tax-free sum of money.
To sum it up… A ROTH Conversion is moving pretax money to after-tax money by paying the taxes now. There are more nuances with ROTH conversions than we covered here, so be sure to work with your financial advisor and accountant before considering this. We see the long-term value of a ROTH conversion, and a down market makes it even more attractive as account values have declined and tax-free money in retirement is priceless.