What is a Roth Conversion?

When saving for retirement, it’s important to maximize every dollar you funnel into retirement savings accounts.

The more mileage you can get out of your savings, the better! In order to fully leverage your retirement savings, you need to do a few things:

  1. Start saving early and often. The longer you put money toward retirement, the more time you are able to grow those funds and increase their value.
  2. Increase your savings to capitalize on the “snowball effect” where, over time, your wealth compounds to grow exponentially. 
  3. Reduce taxes owed on your retirement savings when it’s distributed as income after you retire to get more mileage out of your savings. 

One way people accomplish items two and three on that list is by performing a Roth Conversion. This savings tactic is leveraged when an investor wants to reduce the total taxes owed on their retirement income in the future but doesn’t necessarily qualify to open a standard Roth account now. 

What is a Roth Conversion?

A Roth Conversion is where an investor takes all or a portion of their Traditional IRA (or 401k) balance and converts it to a Roth IRA. The funds that you move were contributed originally to a “Traditional” IRA or 401k account with pre-tax dollars. Then, when you choose to “convert” the funds, you pay income taxes on that money. However, once the taxes are paid now, your money will grow tax-free and distributions will also be tax-free in retirement.

When Do People Use a Roth Conversion?

Many individuals are looking to perform Roth conversions in the coming years because the Tax Cuts & Jobs Act of 2017 has offered lower tax rates that are set to expire after 2025. So, the tax you pay on the funds you convert now is lower than it could be in the future if tax rates are increased. 

However, setting current tax rates aside, the Roth conversion appeals to investors because most investors assume that they will be in a higher tax bracket when they retire than they are now.  This means that paying taxes on funds you convert now may mean paying less than you would have if you had paid taxes on distributions in retirement. This is another way that people choose to maximize their retirement dollars and extend the life of their savings both for themselves and their future beneficiaries.

What Do You Need to Consider Before Moving Forward?

Before pursuing a Roth conversion, you need to consider several things:

  1. Are these funds truly for your retirement or leaving a legacy? Roth IRAs penalize investors for taking distributions before the funds have been invested for 5 years. 
  2. Will you be in a higher tax bracket when you retire? When retirement savings begin to pay out through Required Minimum Distributions (RMD), the annual amount could be significant.
  3. Will you be able to cover the taxes owed now on the funds you’re converting? If you plan to cover the taxes owed with the funds you convert, you’ll not only miss out on the full benefit of the conversion. If you are younger than 59 1/2 , you’ll also be subject to the 10% penalty for the funds not converted that were used to pay your taxes. 
  4. Assuming the funds are pre-tax currently, will counting them as part of your taxable income this year move you into a new, higher tax bracket? Proper tax planning is important to avoid surprises that cost you more than you envisioned.

Although Roth conversions are often viewed as an investor’s “silver bullet” there are scenarios where it may be wise to avoid them. If you are single and your account balance is low, you plan to use the funds in five years or less, or eventually wish to gift the funds to a charity, a Roth conversion may not be for you.

Don’t Go It Alone

Roth conversions are an interesting tool that can help investors maximize their retirement savings. However, they aren’t for everyone, and going through the conversion process can feel complex. A fee-only financial planner can help you build a unique strategy to boost your retirement savings and assist you with a Roth conversion if that’s a beneficial part of your plan. Want to learn more? Contact us today. 

Wood Smith Advisors, a woman-owned Registered Investment Advisor (RIA), is a fee-only financial services firm that partners with its clients to simplify their financial lives. We focus on women, entrepreneurs, and individuals with complex financial situations, providing objective and competent advice, education and services to help them develop and build their businesses and reach their financial goals. We can be reached by clicking here.

"Finance Made Simple" blog posts are intended for educational purposes and not for specific advice. Each person’s situation is different. Consult your financial advisor for advice relating to topics discussed.

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