MoneyDo: Consider A Roth Conversion
Many folks nearing retirement have amassed a significant nest egg in a retirement account. Traditional retirement accounts have special tax circumstances: funds are contributed to these accounts before the associated income tax has been paid, reducing taxes you’d pay on that amount in the current year. The contributions are called “tax-deferred,” because the income tax on the contribution must be paid when funds are withdrawn.
Saving for retirement with a traditional retirement account often makes sense because taxes are often higher when we’re working – especially in our peak earning years in the middle and end of our career. Tax-deferred status allows you to pay the associated tax later, when your work status has changed to retirement when most people are in a lower tax bracket.
In this week’s edition of the Money Do we encourage you to explore another option: consider if it makes sense to withdraw money from your retirement savings account and convert it to a Roth IRA: a Roth conversion.
Roth IRAs are funded with after-tax dollars; meaning the contributions are not tax-deductible. However, all future growth in the Roth IRA is tax free and no tax is due when funds are withdrawn. We therefore suggest considering the benefits and drawbacks of a Roth IRA, and the impact it could have on your tax situation.
BENEFITS OF A ROTH IRA
- Once funds are deposited into a Roth IRA, they can be withdrawn free from further tax
- This creates a tax-free “bucket” of savings which offers tax diversification throughout retirement
- Roth IRAs aren’t subject to required minimum distributions
- Provides insulation against increases in future tax rates by paying the tax now
- Economic stress caused by the recent pandemic and possible political change could increase income tax rates in the future
DRAWBACKS OF A ROTH IRA
- Taxes must be paid up front
- Growth in the account can’t be withdrawn for 5 years or when the owner is 59 ½ years old.
WHEN IT MAKES SENSE TO CONVERT TO A ROTH IRA
- Generally, after retirement but before required minimum distributions begin.
- Lower income years such as extended periods between jobs or exceptionally low commission years.
Essentially, a Roth conversion is a tax management technique. The overall idea is to save money in a tax deferred retirement plan when income is high and convert it to a Roth IRA in years when income is low, creating tax efficiency in your financial plan.
You may be able to handle a Roth conversion yourself, but we suggest consulting with an advisor you can trust, probably a Certified Financial Planner ™, to help evaluate if this strategy is right for you.