The Tax Advantages of a Roth Conversion
Understand the tax implications before converting all or a portion of a Traditional IRA to a Roth. A strategic Roth conversion could help lower your taxes, provide greater retirement income flexibility, and improved estate planning.
Refresher. Congress created individual retirement accounts (IRAs) in the 1970s and then expanded their use in the '80s providing tax incentives to encourage Americans to save more for retirement.
There are two basic IRAs, Traditional and Roth. Here's a breakdown of key features:
| Traditional | Roth | |
| Contributions | Pre-Tax | Post-Tax |
| Growth | Tax-Deferred | Tax-Free |
| Withdrawals | Taxable | Tax-Free |
| Required Mandatory Distributions (RMD) | Age 72 | None |
Why Traditional or Roth? The Traditional IRA provides an upfront tax incentive, whereas the Roth delivers it on the backend with tax-free withdrawals. You would most likely choose the Traditional IRA if you thought your tax bracket was higher when contributing to than when retired and taking distributions. Conversely, a younger worker, or someone in a lower tax bracket who anticipated being in a higher tax bracket in the future or when retired, would likely choose the Roth over the Traditional IRA. In other words, the decision as to which type of IRA, pre-tax or post-tax contribution, comes down to an expectation of your current tax rate versus your future tax rate when retired.
What's a Roth Conversion? A conversion is when you pay an upfront tax to convert your Traditional IRA to a Roth.
Why Consider a Conversion? Income and taxes change over time. What made sense years ago from a tax and savings perspective could be entirely different today. Financial planning analysis can help in this regard. It's entirely possible, depending on the size of your IRA, that the required distributions, starting at age 72, will throw you into a higher tax bracket than you might be anticipating. Whether you need the income or not, you'll be required to take the distribution, pay the tax, and then most likely reinvest the proceeds back into a taxable account. And, as you age, the size of the RMD increases. The Roth conversion can eliminate this dilemma. You will pay an upfront tax, but all future growth and withdrawals will be tax-free, as well as it will be your option of whether to take them or not.
Strategies for converting. You'll want to manage and minimize the taxes you pay on the conversion. Conversions at a younger age with more time for assets to grow tax-free can be more advantageous. You might want to convert in a year when your income is lower or when the account's value drops in a market sell-off. It could also make sense to wait until you retire and the period before RMD's begin when income is naturally lower. No matter how or when you do it, try not to use the proceeds to pay the taxes, diluting the benefit. As always, consult your financial advisor and accountant for additional input and advice.
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