Roth conversion of your tax-deferred retirement savings can be a brilliant move. Learn the must-know rules and tax implications of Roth Conversion before you decide if it is right for you.Retirement Calculator
What is a Roth Conversion?
Roth Conversion is the process of transferring the full or partial balance of your existing traditional IRA into a Roth IRA. The conversion effectively moves tax-deferred retirement savings into tax-exempt dollars.
A critical downside of Roth conversion is that you need to pay income taxes on the converted amount. For that reason, it is beneficial to have additional taxable savings to cover the tax cost of the conversion.
Unfortunately, not everybody is the right candidate for Roth conversion. Consider your specific financial and tax circumstances before moving forward.
Watch your tax bracket
A crucial element of any Roth conversion decision making is your taxes. The strategy becomes feasible during low tax years or whenever you expect higher tax rates in the future. Higher future tax rates make a Roth IRA more appealing, while lower future tax rates would make a traditional IRA more attractive.
Consider your investment horizon
Generally, you will achieve a higher benefit if you perform your conversions earlier. Your Roth IRA will have time to grow tax-free for longer and will offset the cost of paying taxes upfront.
Roth IRA 5-year rule
When you do a Roth conversion, you need to be mindful of the 5-year rule. The rule requires that 5 years have passed since your first Roth contributions before taking penalty-free withdrawals of your tax-free earnings.
You can still withdraw your original contributions at any time. However, your earnings are subject to the 5-year minimum restriction. If you do not meet the minimum 5-year holding period, your profits can be subject to ordinary income tax as well as a 10% penalty for early withdrawal.
Furthermore, each separate Roth conversion has a five-year limit. The Five-Year clock begins ticking on January 1st of the year when you make the conversion.
The advantages of Roth conversion
Converting your tax-deferred dollars to Roth RIA can have several financial and estate benefits.
Your money grows tax-free
Savings in your Roth IRA grow tax-free. As long as you meet the 5-year rule, you will not owe any taxes on your distributions. Roth IRA contributions are pre-tax. You are paying taxes beforehand but do not owe taxes on any future earnings.
In comparison, contributions to Traditional IRA are typically tax-deductible. When you take distributions from Traditional IRA, you have to pay ordinary income taxes on your entire withdrawal amount.
If your future tax rate is uncertain for various reasons, you may want to diversify your tax risk through Roth conversion. You will benefit from holding both tax-deferred and tax-exempt retirement accounts. Tax diversification gives you more flexibility when it comes to future retirement withdrawals and tax planning.
Asset location is a tax-optimization strategy that takes advantage of different types of investments, getting different tax treatments. Investors who own a variety of taxable, tax-deferred, and tax-exempt accounts can benefit from asset location. By doing Roth conversion, you can determine which securities should be held in tax-deferred accounts and which in Roth accounts to maximize your after-tax returns.
No Required Minimum Distributions
Traditional IRA rules mandate you to take taxable required minimum distributions (RMDs) every year after you reach age 72.
Alternatively, your Roth IRA does not require minimum distributions at any age. Your money can stay in the account and grow tax-free for as long as you want them.
Leave behind a tax-free legacy
The Roth IRA can play a crucial role in your estate planning. Your heirs who inherit your Roth IRA will receive a tax-free gift. They will be required to take distributions from the account. However, they will not have to pay any income tax on the withdrawals if the Roth IRA has been open for at least five years. Roth IRA is especially appealing if your heirs are in a higher tax bracket than you.
Keep Social Security income tax and Medicare Premiums low
Another hidden benefit of the Roth conversion is it could potentially lower your future social security income tax and Medicare Premiums.
Up to 85% of your Social Security checks can be taxable for individuals earning more than $34,000 and families receiving more than $44,000 per year.
Your Medicare Plan B premium will be calculated based on your reported income-related monthly adjustment amount (IRMAA) 2 years prior to your application. Even a dollar higher can push in a higher premium bracket,
Roth Conversion Strategies
With some planning, Roth IRA offers substantial tax-free benefits. Due to income limits, many retirement savers end up with significant amounts in tax-deferred accounts such as 401k and Traditional IRA. These plans give you initial tax relief to encourage retirement savings. However, all future distributions are fully taxable.
The Roth conversion may help you reduce your future tax burden and unlock some of the befits of Roth IRA. Here are some of the strategies that can be helpful in your decision process.
End-of-year Roth conversion
The stability of your income can be critical to your success. Each conversion must be completed by the end of each tax year. If your income is constant, you can process the conversion at any time. If your income is less predictable, your only choice will be to make your conversions towards the end of the year when you will have more visibility on your earnings.
Conversion during low-income years
The Roth conversion is generally more attractive during your low-income years when you will be in a lower tax bracket. The additional reported income from the conversion will add on to your base earnings. If you do the math right, you will be able to maintain your taxes relatively low. Analyze your tax bracket and convert the amount that will keep in your desired marginal tax rate.
Conversion during a market downturn
Another popular strategy is performing Roth conversion during a market downturn. A Roth conversion could become appealing if your Traditional IRA is down 20% or 30%. At the same time, you have a long-term investment horizon and believe that your portfolio will recover the losses over time.
Your largest benefit will come from the potential tax-free portfolio gains after the stock market goes higher. With this approach, your underlying taxes take a lower priority versus the ability to earn higher tax-free income in the future. However, you still need to determine whether saving taxes on future gains provides a higher benefit than paying higher taxes now.
Monthly or quarterly cost averaging
Timing the stock market is hard. The cost averaging strategy removes the headache of trying to figure out when the stock market will go up or down. This approach calls for making planned periodic, monthly, or quarterly, conversions. The benefit of this method is that at least part of your portfolio may benefit from lower stock values. It is a way to hedge your bets on surprising stock market moves. If your portfolio goes higher consistently throughout the year, your earlier conversions will benefit from lower stock values. If the stock market goes down in the second half of the year, your later-in-the-year conversion will produce a higher benefit.
Roth Conversion barbelling
This strategy makes sense if your annual income is variable and less predictable. For example, your income fluctuates due to adjustments in commissions, bonuses, royalties, or other payments. With barbelling, you perform two conversions per year. You make the first conversion early in the year based on a projected income that is at the high end of the range. The second conversion will occur towards the end of the year, when your income becomes more predictable. If your income is high, you may convert a much smaller amount or even nothing. If your earnings for the year are at the lower end of expectation, then you convert a larger amount.
Roth Conversion Ladder
As I mentioned earlier, each Roth conversion is subject to its own 5-year rule. The 5-year period starts on January 1st of the tax year of your Roth conversion. Every subsequent conversion will have a separate 5-year holding period.
The Roth Conversion ladder strategy requires a bit of initial planning. This approach stipulates that you make consistent annual conversions year after year. After every five years, you can withdraw your savings tax-free from the Roth IRA. In effect, you are creating a ladder similar to the CD ladder.
Keep in mind that this strategy only makes sense under two conditions. One, you can afford to pay taxes for the conversion from another taxable account. Second, your future taxable income is expected to increase, and therefore you would be in a higher tax bracket.
Roth Conversion can be a great way to manage your future taxes. However, not every person or every family is an ideal candidate for a Roth conversion. In reality, most people tend to have lower reportable income when they retire. For them keeping your Traditional IRA and taking distributions at a lower tax rate makes a lot of sense. However, there are a lot of financial, personal, and legacy planning factors that come into play. Make your decision carefully. Take a comprehensive look at your finance before you decide if Roth conversion is right for you.