Should you Look at a Roth Conversion?

Korey Knepper |

No one likes taxes, except for the people who get paid by them and enact them. That is what has always made the Roth account type so attractive. You pay the taxes now and can pull the money out later tax free. This is the opposite of the Traditional route of contributing before you are taxed, and being taxed when you take the money out. However, the government will make sure they get their taxes, so they have what are called Required Minimum Distributions, or RMDs for short. For a lot of people, this is not a big deal. They will already be using their Traditional IRA in retirement, so the RMD portion will not hurt them at all. However, this does not fit everyone, and a Roth Conversion might make sense for you.

What is a Roth conversion? It is simply pulling money out of our Traditional account, and paying taxes on it, and immediately rolling it into a Roth IRA. Roth IRAs are not subject to RMDs like the traditional account is. To understand if this option is a fit for you, we need to understand RMDs a little bit more. RMDs are required to start at age 73, and that number jumps to 75 in 2033 (those born after 1960). The IRS uses a table, that as you get older, the factor gets smaller. So, for example, the factor for someone turning 75 in 2024 is 24.6. We then find your year-end balance for your traditional accounts and divide that by the factor. So, if we have an end balance of $500,000, we will divide that by the factor and get an RMD of $20,325. This RMD is not an incredibly significant one, however, the factor gets smaller every year. If we use the same account value for someone who turns 85 in 2024, we get a factor of 16, and an RMD of $31,250. This is still a reasonable number, but you can see how taking out increasingly every year could deplete what you worked your whole life to build.

Where does the Roth conversion fit? If you are in retirement, or approaching retirement, and have enough income in retirement that your assets will not be a significant part of your income. It can also be used if your only income is going to come from social security, and you have a significant amount of assets in your Traditional account (typically over 2 million). The other benefit of the Roth account type is that it does not affect your Adjusted Gross Income like the traditional does, which can subject up to 85% of your social security to be taxable. These are the typical situations where a Roth conversion would be considered.

How does it work and what are the downsides? If someone meets the criteria for a Roth conversion, then we would like to execute it at the end of the year. This way we know where we stand on taxes. Then we can either deplete the Traditional account over a period of years, or we can fill up a tax bracket. Why idea of the latter is if you are going to pay 22% tax on all withdrawals either way, then why not fill the rest of that bracket with a conversion to Roth. Say a married couple is retired, and bringing in $100,000 of taxable income, they would be in the 22% tax bracket in 2023 and could convert an additional $90,750 to Roth. There are two major downsides to this, one being that $90,750 in the traditional account would be converted to $70,785 in a Roth account. The other issue is the 5-year rule. This rule states that no earnings can be pulled from the account over the next five years. You can pull out what has been contributed, however, you cannot pull out the earnings without incurring a penalty. This is one of the main factors to consider when determining whether a Roth conversion is right for you.

A strong Roth conversion plan has the power to change financial security in retirement, as well as the wealth that is left to your family. When someone inherits a Traditional IRA, they will have RMDs associated with it, and must pay income tax on those distributions. They can also be subject to the ten-year rule, where the account must be emptied ten years from death. The Roth has similar rules, however, since the taxes were already paid, the beneficiary can take the money out tax free.

If you are considering a Roth conversion and would like to see if it is the correct fit for you, use this link to set up a phone call with a registered representative that can help you. As always, thanks for reading.