Roth IRAs can be a great tool when it comes to both tax strategy and income planning in retirement. While direct contributions to Roth IRAs are constrained by income limits, that doesn’t mean Roth accounts are entirely inaccessible. We occasionally suggest Roth conversions to our clients. This article explores why we might make that recommendation by answering a few key questions:

-       What are the benefits of a Roth IRA?
-       What is a Roth conversion?
-       When does a Roth conversion make sense?
-       How does a Roth conversion work?

What are the benefits of a Roth IRA?

To understand why you might do a Roth conversion, you first need to understand the difference between traditional and Roth IRAs:

The money you contribute to a traditional IRA is exempt from federal income tax when you contribute it; you pay income taxes on the money when you withdraw it from your account, usually in retirement. With Roth IRAs, you contribute money after taxes, but don’t have to pay federal income tax on the money when you withdraw it, usually in retirement. In both cases, the money grows tax-free.

Financial advice blogs often favor traditional IRAs over Roth IRAs for three reasons:

1.     Your income while you are working is typically higher and contributing to a traditional IRA with pre-tax money reduces your taxable income.
2.     No one likes paying taxes now when they can pay them later. 
3.     Most people expect that their income will be lower in retirement, so the income tax burden on IRA withdrawals may also be lower.

Keep in mind, however, that tax rates can and do change over time. As a point of reference, the top marginal rate topped 90% in the 1940s. It’s hard to know what your tax rate will be in retirement.

Plus, when you’re living on a fixed income, paying income tax may feel like more of a strain, and being able to withdraw money from a Roth IRA tax-free may be helpful. Additionally, Roth IRAs don’t come with required minimum distributions (RMDs) in retirement.

The criteria around income taxes and RMDs make Roth IRAs a potentially valuable tool in estate planning, as your heirs wouldn’t need to take RMDs or pay income taxes on their distributions.

Roth IRAs also let you tap into principal contributions after a waiting period, whereas withdrawing money from a traditional IRA before you turn 59½ comes with a penalty.

These benefits make Roth IRAs a potentially helpful part of a financial plan, particularly if you are already contributing to a pre-tax retirement account, such as a traditional IRA or 401(k).

What is a Roth conversion?

In a Roth conversion, you take the money from a pre-tax retirement account and roll it over into a Roth IRA.

There are no income restrictions on converting a traditional IRA to a Roth IRA, so clients with higher incomes might use conversions to access the advantages of Roth IRAs.

When you convert money from a traditional to a Roth IRA, you pay taxes on the entire sum you convert, regardless of whether it was part of your principal contribution or earnings. Depending on the size of your account, there’s the potential for a significant tax liability. The tax liability occurs in the calendar year you make the contribution.

When does a Roth conversion make sense?

We may advise clients to employ Roth conversions in years when they have less income and are in a lower tax bracket (due to a job change, for example) or during a bear market, as the amount may be lower due to the downturn.

If you to have less income or a smaller account balance, you may be reluctant to pay a larger tax bill. However, this type of strategic move may help you save money in retirement, so it’s worth considering as part of a broader financial plan. (We always work with clients to evaluate the pros and cons and ensure that the additional tax liability makes sense.)

Roth conversions require quite a bit of planning since they must take place during the traditional calendar year—January through December. If you were to convert an IRA to a Roth IRA in January, you’d pay the taxes the following year, or roughly 15 months later. This is different from most retirement accounts, which allow you to contribute or make changes through the April 15 tax deadline.

Prior to December 31st, it may be difficult to determine your tax situation for a given year.   Working with a financial advisor and/or tax professional can help evaluate if a Roth conversion is right for you. 

How does a Roth conversion work?

One of the benefits of working with a financial advisor is that we handle the logistics of a conversion. We may also coordinate with your tax preparer.

Once a client authorizes a conversion, we decide whether to use an existing Roth IRA account or open a new one. Next, our team handles the logistics of moving assets from the pre-tax IRA to the Roth IRA account. You will receive a Form 1099-R to report the amount of the conversion, which is subject to income tax.

It’s important to note that you can’t undo a Roth conversion, so proper planning is essential.

If you think a Roth conversion might make sense for you this year or if you have questions about how it may fit into your overall plan, let’s find time to discuss.