Roth Conversions .. What You Need To Know.
Converting your pre-tax Traditional accounts (IRAs, 401ks, 403bs) to Roth accounts can make an awful lot of sense in certain circumstances. But you need to do your due diligence beforehand.
You may already be aware about the tax advantages of investing for retirement using a Roth retirement account (IRA or 401k/403b). Tax-free growth, tax-free withdrawals in retirement, no required minimum distributions, possible penalty-free early access to funds under certain conditions and a tax-free legacy to heirs?
If your money gets to grow from the start in a Roth account, that’s great. But what if your retirement savings started out in a regular, pre-tax Traditional 401k/403b or IRA - can you still take advantage of a Roth?
The answer is yes and the means by which you can accomplish this is the Roth conversion. But it is absolutely vital to understand not just the benefits but also the tax consequences of Roth conversions.
You should never, ever attempt a Roth conversion of any kind without consulting a qualified tax professional beforehand and having the tax consequences fully explained to you!
What Is a Roth Conversion?
A Roth conversion is simply the process of transferring funds from a tax deferred retirement account, like a pretax 401k/403b or a Traditional or Rollover IRA, into an equivalent tax free Roth account.
There’s no limit on how much money you can convert in a single year. It also doesn’t matter what your income or tax filing status is, anybody and everybody can do a Roth conversion.
There are also no limits, minimums or maximums on how many Roth conversions you can make in a single year, whether you want to convert all your Traditional, pre-tax accounts in one large transfer or break them down into multiple conversions over the course of the year or multiple years.
What Are the Benefits of a Roth Conversion?
There are four main benefits to making Roth conversions, which all derive from the unique features of Roth accounts ..
1) Tax-Free Growth on Your Retirement Savings
After a Roth conversion, all of your investment growth will be shielded from any taxes inside of the Roth account. That means you will never have to pay a penny in taxes on the gains made from your investments.
This is a huge deal. If you let your investments grow for a multi-decade period of time, that can lead to an enormous amount in tax savings.
2) No Taxes on Your Withdrawals in Retirement
When you invest for retirement with a Traditional pre-tax retirement account, you’re investing with pre-tax dollars, i.e. you don’t pay any taxes on the money you put in - at least, not right away.
Instead, you get a tax break now in the form a tax deduction on your contribution (i.e. whatever you contribute is knocked off your federal and state taxable income for the year of the contribution). However, you’ll pay taxes on the growth and withdrawals in retirement later. Whatever you take out in retirement is added to your income that year and you are taxed accordingly at your prevailing marginal tax rate (federal and state) at that time. When you hear reference to “tax deferred growth”, that’s what it means.
A Roth conversion solves that problem. Once you convert your Traditional tax-deferred retirement savings to a Roth account, you’ll effectively pre-pay your taxes now in order to enjoy completely tax-free withdrawals in retirement (as long as the Roth account has been open for five years - see below).
In effect when you look at the balance of your Traditional IRA or pre-tax 401k/403b, only around two-thirds of it (depending on your tax bracket and what state you live in) is actually yours. The rest will ultimately go to the taxman.
By contrast, when you look at the balance of your Roth IRA or Roth 401k/403b, it’s all yours. You own 100% of what is in there.
3) More Control Over Your Retirement Withdrawals
Remember, none of the money inside your Traditional, pre-tax 401k/403b or IRA has ever been taxed. But at some point, the IRS is going to come knocking. That’s where Required Minimum Distributions (RMDs) come in to play.
If you have a Traditional IRA or 401k/403b, you’ll be forced to start taking money out of your account once you reach age 73 (the exact date can be something of a moving target, but as of now it’s around there). Ready or not, you’ll have to start paying those taxes at your prevailing marginal tax rate once those RMDs kick in.
Because the IRS has already been paid the taxes on every contribution, Roth IRAs and Roth 401ks/403bs aren’t subject to any RMDs. This means you are in complete control (subject to the five year rule - see below) of how and when you take money out of your account in retirement.
I wrote a deep dive into RMDs which you can read here.
4) A Better Legacy For Your Heirs
If someone inherits a Traditional IRA, whether directly or indirectly as a beneficiary of a pre-tax 401k/403b balance, they effectively inherit the tax obligation of the person who died. Withdrawals from the inherited account may need to be completed within a specified time period depending on a number of circumstances, but one thing that will always be true is that with every withdrawal will come a tax bill.
If someone inherits a Roth IRA, whether directly or indirectly as a beneficiary of a Roth 401k/403b balance, they get to keep the whole thing. There are no tax consequences to any withdrawals by your heirs.
If you are fortunate enough to be in a position whereby you feel that your Roth account is unlikely to be tapped into during your lifetime (not a possible scenario with a Traditional pre-tax account) and that it will eventually be fully passed to your heirs, you can asset-allocate it more aggressively since the effective time horizon is no longer that of when you’ll start taking money out, but could be extended well beyond that depending on the nature (spouse/non-spouse) and age of your heirs.
I am happy to discuss this strategy with Anglia Advisors clients.
What Are the Tax Implications of Roth Conversions?
So, when you convert money from a Traditional pre-tax account to a Roth account, you’ll pay income taxes in the year of the conversion on whatever amount you’re moving into the Roth account. In other words, whatever amount you convert will added to your income in the year of the conversion and you’ll be taxed accordingly. But then you won’t have to worry about taxes on that money ever again.
Never withhold taxes from the amount you’re converting. Always pay the taxes separately when you file your tax return the following spring. Remember, you cannot use the money you convert to pay the tax bill associated with the conversion. You will have to pay it using other assets you own elsewhere (see below).
Also remember that the addition of the amount that you convert to your taxable income for the year might, of itself, bump you into a higher tax bracket. This where the critical pre-conversion discussion with your tax professional comes in.
I’m going to say it again .. You should never, ever attempt a Roth conversion of any kind without consulting a qualified tax professional beforehand and having the tax consequences fully explained to you!
How Do I Implement a Roth Conversion?
Depending on what situation you find yourself in, there are a couple of ways to implement a Roth conversion ..
In-Plan Rollovers: Traditional 401k/403b → Roth 401k/403b
If your employer-sponsored plan offers a Roth option (plans are increasingly doing so) in your 401k/403b, you can not only choose for a portion of your contributions to go into the Roth bucket, but you can also move some or all of your existing balance from the pre-tax bucket to the Roth bucket. In this scenario, the money stays in the employer-sponsored plan, but converts from the pre-tax traditional option to the Roth with the same tax consequences described above.
If you’re already investing in Roth 401k/403b at work, your contributions are going in with after-tax dollars, so you’re all set there. But remember that any employer matching contributions are likely a different story. Those matching funds are almost certainly going into the pre-tax bucket. You should have the option to move those employer match funds into your Roth bucket with in-plan rollovers.
If your employer does not yet offer a Roth feature, you will need to wait until either a) they introduce the option, or b) you stop working for that employer, after which time you will be able to roll the 401k/403b into a Traditional IRA and then have the option to convert (see below).
Traditional/Rollover IRA → Roth IRA
If you have a Traditional IRA balance that you have previously funded either through direct contributions to the IRA or by having rolled in previous employers’ workplace plans, you can convert some or all of it to your Roth IRA (which you’ll need to open if you don’t yet have one in place).
Most platforms like Schwab, Fidelity, Vanguard, Betterment etc. make it easy to effect a direct transfer conversion from Traditional to Roth. It’s obviously easier if the Traditional and Roth accounts are both held at the same provider. It can often be done directly from the online client dashboard or else you can work with your advisor or a representative on the phone to make the conversion.
And again .. You should never, ever attempt a Roth conversion of any kind without consulting a qualified tax professional beforehand and having the tax consequences fully explained to you!
Backdoor Roth IRA Contributions
I explain the process of making Backdoor Roth IRA contributions in a separate post here. This applies to those earning above the Roth IRA contribution income limit and uses the Roth conversion technique, but has its own different set of considerations - particularly those related to the important “Pro-Rata” rule, which is explained in the article.
When Does a Roth Conversion Make Sense?
A Roth conversion isn’t for everyone. For instance, for someone in their peak earnings years and in as high a marginal tax bracket as they are ever likely to be, a Roth conversion at that time makes little sense as it effectively brings forward the income tax obligation into a zone when the bill will be at its highest.
Here are some scenarios where it may be the right call ..
1) Your Timeline to Retirement is More Than Five Years
The money you convert into a Roth IRA must stay in the account for a five-year period. If you withdraw money before the five years are up, you may be liable for a penalty and, depending on how much you withdraw, additional income taxes. It makes no sense to do a Roth conversion if you’re just going to take the money out a few months or a small number of years later.
A longer runway to retirement also gives you the opportunity to potentially completely drain the tax deferred account in favor of a tax free one using periodic annual conversions ahead of age 73, completely removing the need for any RMDs.
2) You Are Able To Pay the Taxes With Cash on Hand
As I have alluded to already, you should only consider a Roth conversion within an employer plan or between IRA types if you have money in the bank to pay for the additional income taxes you’ll owe on the money you’re converting in the year that you do so. You must be able to afford to pay the tax bill for a conversion with available cash since you cannot use any of the converted amount to pay it.
If you can’t do that, don’t convert. It’s as simple as that and that is why you need a tax professional to provide an estimate in advance of what the tax bill associated with the conversion will be and be aware of where you will get that money from.
Remember, you don’t have to convert your Traditional pre-tax funds all at one time. Indeed it often makes little sense to do so. The process can be carried out over a number of years. You could convert some of your funds this year (whatever amount you can afford to pay taxes on) and then gradually convert the rest later over a number of years in more manageable, bite-sized chunks.
3) You Are Experiencing or Anticipate a Decline in Income
If you (or your household if you are filing taxes jointly) are experiencing or anticipate a year or more of lower income for any reason that could cause you to fall down one or more tax brackets, then the associated tax bill for a conversion will be lower since it is dependent upon your prevailing marginal income tax rate in the year of conversion.
Examples of this may be early retirement or semi-retirement, periods of unpaid leave (parental leave, sabbatical etc.), years where income is negatively impacted by a period of voluntary or involuntary unemployment, at the time of a career change that may involve a temporary reduction in household income levels during a transition etc.
4) Following a Significant Market Decline and Fall In Asset Values
When markets fall heavily, the value of invested portfolios inevitably declines. Therefore, the total balance in the account under consideration for conversion will be lower. So a partial conversion of a fixed amount of dollars in this case will represent a larger percentage of the entire balance than it would have done when stock and bond prices were higher.
This can help accelerate the process and limit the tax cost of a full conversion and when the prices of the securities subsequently recover, they will do so within an account that is entirely tax-free.
One more time, as it’s impossible to overstate this ..You should never, ever attempt a Roth conversion of any kind without consulting a qualified tax professional beforehand and having the tax consequences fully explained to you!
For Anglia Advisors clients, I am happy to offer assistance in coming to a decision on and/or implementing this strategy.
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