The Grapes of… Roth Conversion: A Fruitful Strategy for Retirement Wealth

Tax deferred? Tax free? Tax advantaged? It might sometimes feel a bit taxing to think about the tax implications of a Roth conversion.

However, it is probably worth your brain power because a Roth conversion can be tremendously beneficial in the right circumstances.
Roth Conversion

What is a Roth Account?

A Roth account is a type of 401k or IRA.

The main difference between a Roth account and a traditional retirement savings account is tax treatment:

  • Money in a traditional 401k or IRA grows tax deferred, meaning that you pay taxes on the money when you withdraw the funds (and no taxes at all when you invest the money).
  • Money in a Roth account grows tax free.  Contributions to this account are made with after-tax earnings, but you owe zero taxes when you withdraw the funds — no matter how much the account has grown.  (Another difference is that Roth IRAs do not have Required Minimum Distributions (RMD), although Roth 401ks do.)

What is a Roth Conversion?

A Roth conversion is when you take money that you have in a traditional 401k or IRA account and move it into a Roth 401k or IRA.

When you do this, you will need to pay taxes on the money you withdraw.  However, any future gains will grow tax free.

5 Times When a Roth Conversion Might Be a Great Idea

Roth conversions can sometimes really save you money on taxes, but they could also cost you.  It all depends on your circumstances.

While you should always consult a tax expert before doing a Roth conversion, here are 4 times when it will likely benefit you:

1. Higher Future Tax Rate: If you think that you will be paying higher taxes in the future, then converting to a Roth account is probably a good move.  Whatever money you withdraw now will be taxed at your current rate but not at all in the future.

Tax considerations to consider might include:

  • Do you intend to relocate in the future?  What is the difference between your current and future state’s tax rates?
  • Do you need the money from Required Minimum Distributions (RMDs) and will this income put you in a higher tax bracket?

2. Are you hoping to leave money to heirs?  In many cases, your beneficiaries will pay less in taxes if the money is in a Roth account instead of a traditional account.

3. High Rate of Return:  Another situation when a Roth conversion could reduce taxes is when you think that the money in your retirement account will likely earn a relatively high rate of return.  If you do a Roth conversion before you see these big gains, then you will be paying taxes on a lower dollar amount and all growth in that account will be tax free.

4. Withdrawals Are a Long Way Off: If you are a long way off from needing to withdraw from your traditional 401k or IRA, then a Roth conversion may be a good idea.

5. You Don’t Need Money from RMDs: Starting at age 70.5, you are required to withdraw money from traditional 401ks and IRAs.  These withdrawals can be a nuisance and can bump you into a higher tax bracket.  If you don’t need the income a RMD provides, then it might make sense to convert your traditional accounts to a Roth.

Rethink a Roth Conversion in These Instances

Can You Afford the Short Term Taxes?: When you take money out of a traditional account and convert it to a Roth account, you will owe taxes on the amount you convert.  You need to be sure that you can afford this expense.

NOTE: Many people convert small amounts one year at a time to spread out the tax burden.  You do not need to convert an entire account.

You Have a Traditional 401k at Your Current Employer: You usually can not convert a traditional 401k you have with a current employer to a Roth IRA.  You must wait until you have left the employer.

The Conversion Will Trigger Extra Taxes or Costs:  When you do a Roth conversion, all of the money you convert from your traditional IRA or 401k will be taxed as income.   However, it is not only the taxes that are costly, the extra income could impact other expenses:

  • College Costs: if you are paying for college, the income could impact financial aid packages.
  • Medicare: If you are 65 or older, the more money you earn (including withdrawals from IRAs and 401ks taxed as income), the more you might need to pay for Medicare.

You Withdraw the Funds Instead of Converting: If you withdraw money from a tax advantaged account before you are 59 1/2, then you will usually have to pay a 10% penalty in addition to the income taxes you owe.

This does not mean that you can’t convert the money, you just need to do the right kind of paperwork to transfer your funds from a traditional account to a Roth account.

Consult an Expert and Make Sure that Tax Strategies Are Part of Your Overall Retirement Plan

Taxes are confusing and complicated and are perhaps evolving.  Before converting money to a Roth account, you may want to consult with a certified financial advisor or a tax accountant.

You also want to make sure that your tax strategy is part of your overall retirement plan.  The NewRetirement retirement planning calculator is a rich and detailed tool that addresses many different aspects of personal finance.

The tool enables you to try different scenarios.  Try switching the account status from a traditional account to a Roth account and immediately see the impact on your retirement wealth.

This retirement calculator makes it easy to get started and maintain a robust and reliable plan for your future.

Find out how much you should save for retirement




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