TIME FOR A ROTH CONVERSION?

If you are faced with a lower income bracket due to the coronavirus pandemic, a Roth IRA conversion may be advantageous.  Additionally, a Roth IRA conversion may be a savvy strategy for you right now if you feel taxes will be higher down the road when you retire.  

What is a Roth conversion?  

A Roth conversion is “a way to convert funds from a traditional IRA (individual retirement account) into a Roth IRA” (Elk, 2020).  Unlike contributions, there is no limit on the amount of conversion you can make.  However, at the time of conversion you pay tax on the dollars converted, so you may find it a good strategy to make partial conversions over a few years to avoid a heavy tax burden in just one year.  

Benefits of a Roth IRA

A Roth IRA provides tax free distributions in retirement!  That’s right, if you take qualified distributions from your Roth IRA, you receive the funds without having to pay any tax. There are many types of retirement accounts which can be utilized for retirement planning including:

  • 401(k) 
  • 403(b)
  • 457
  • Traditional IRA
  • SEP IRA
  • SIMPLE IRA
  • Roth IRA

Each of these account types has specific rules pertaining to eligibility, deferral limits, early withdrawal penalties, holding periods, tax deferral implications, and distribution requirements to name a few.  When investing in one of these retirement accounts it is important to understand the impact of the account rules.  One of the rules requires account holders to take minimum distributions also known as RMD’s at age 72 (due to The SECURE Act, this age was recently adjusted up from age 70 1/2 to age 72).  When you take your annual RMD you pay tax on the withdrawal.  However, this is not the case with a Roth IRA.  Not only do withdrawals from a Roth IRA come out tax free, but RMDs are not a requirement of a Roth.  

How a Roth IRA works

When investing for retirement in a Roth IRA account, you make contributions with after-tax dollars.  “After-tax income is the net income after the deduction of all federal, state, and withholding taxes” (Kagan, 2020).  Because you contribute income after taxes you are not required to pay tax on this money a second time when you take money back out of your Roth IRA account.  

Like the other retirement accounts mentioned above, the Roth IRA grows tax deferred.  Great, and here is the big difference which may prove to be a plus, if you meet specific requirements, all withdrawals (contributions, conversions, and earnings) will come out tax free.  Tax free withdrawals during retirement, that can have a huge impact for retired folks who need to self generate an income stream once a paycheck stops.  

Contributions (after tax money you put in) always comes out tax free.  Conversions and earnings come out tax free and penalty free if certain requirements are met.  Conversions and earnings have a 5 year holding period and may be taken out tax free and penalty free when meeting special purposes like attainment of age 59 1/2, disability, first home purchase, education, and medical expenses.  Other special purposes may apply.

Roth IRA Conversion Conclusion

A Traditional IRA to Roth IRA conversion will cost you tax dollars today, but down the road you will be able to take withdrawals from your Roth IRA tax free.  This may be a huge advantage in retirement.  Roth IRA’s have their own unique contribution limits, but conversions limits do not apply.  Roth IRA accounts are subject to a 5 year holding period and other special purpose rules in order for distributions to be considered qualified and not subject to tax or penalty.  It is important to consider conversions carefully.  Check with your tax professional and financial planner first to see if this strategy is right for you.    

References

Elk, K. (2020, January 23). How to find out if a Roth conversion is right for you-and how to do one. Retrieved March 20, 2020, from https://www.cnbc.com/2020/01/22/how-to-do-a-roth-conversion.html

Kagan, J. (2020, January 29). What is After-Tax Income? Retrieved March 20, 2020, from https://www.investopedia.com/terms/a/aftertaxincome.asp 

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