The introduction of the Roth account revolutionized the retirement planning landscape. In response to challenges faced by Americans in saving adequately for retirement, the Roth account emerged as a solution, offering the promise of tax-free earnings and withdrawals. It also introduced the flexibility for savers to Roth conversions by converting all or part of their Traditional IRA assets into Roth, adding a strategic tool to retirement savings.
The advantages of Roth accounts are highly compelling: they provide enhanced tax flexibility, eliminate the need for Required Minimum Distributions (RMDs), and offer beneficiaries a tax-free investment vehicle.
However, before you rush off to convert your traditional funds into Roth funds, there are some essential questions you must first ask yourself. You may find that at least at this moment in your life, a Roth conversion isn’t the right move for you.
What is a Roth IRA?
If you are a regular reader of our blog posts, you’ve undoubtedly come across the Roth already. But in case you haven’t, let’s break down exactly what it means to put into a Roth.
A Roth is a retirement account where contributions are funded with after-tax dollars. More specifically, you pay taxes on your contributions before you fund your account and purchase assets. The significant advantage is that qualified withdrawals are tax-free, providing potential tax savings in retirement. However, you must follow some specific withdrawal rules for them to qualify as tax-free.
Roth Withdrawal Rules
Firstly, you can remove contributions at any time for any reason without paying taxes or penalties (more on penalties later). After all, you’ve already paid your fair share. Removing the earnings is a bit trickier, though.
- Withdrawals can be made without penalty after reaching age 59½.
- A five-year holding period is required before making qualified withdrawals.
- Exceptions to the early withdrawal penalty exist for specific life events, including purchasing a first home, covering college expenses, and incurring costs related to birth or adoption.
Be aware of this nuance – just because you are 60 doesn’t mean your withdrawal is qualified. If you funded a Roth at age 58, you will have to wait five years, until you are 63, to qualify for the tax-free withdrawal, though you will not incur penalties.
Penalties
Regarding those penalties. Earnings removed before the age of 59 ½ will be subject to a 10% penalty on top of the taxes you will owe, though there are exceptions. Some notable ones are as follows:
- Made due to total and permanent disability.
- Not exceeding $10,000, utilized for a qualified first-time home purchase.
- Not exceeding the amount of your qualified higher education expenses.
- Used for qualified expenses related to a birth or adoption.
- Applicable if you pass away.
This list is far from exhaustive. The IRS has a complete list of penalty-free withdrawals on its website.
Roth vs. Traditional Retirement Accounts
How does the Roth differ from a Traditional retirement account? Traditional retirement accounts like 401(k)s, or Traditional IRAs allow contributions on a pre-tax basis. The key takeaway is tax-deferred, not tax-free. The money grows tax-deferred, but withdrawals in retirement are subject to ordinary income tax.
They also bear Required Minimum Distributions (RMDs), meaning that at some point, you will be forced to remove a certain percentage of your funds based on your life expectancy or risk incurring (yet another) potential penalty, giving you less flexibility in your tax planning strategy.
Here’s a comparison:
|
Feature
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Traditional Account
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Roth Account
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|---|---|---|
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Contributions
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Pre-Tax
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Post-Tax
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|
Growth
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Tax-Deferred
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Tax-Free
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|
Withdrawals
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Taxed as Ordinary Income
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Tax-Free (if qualified)
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|
RMDs
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Yes
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No
|
When Should We Do a Roth Conversion?
You should execute a Roth conversion if you feel that by doing so, your lifelong tax burden will be less than if you deferred and paid taxes later. Naturally, coming to that conclusion is a difficult one. You must also keep in mind that a conversion may lead to a high tax bill for the year of conversion, potentially pushing you up a tax bracket, and the tax bill may be more of a burden than the eventual savings you would hope to gain.
Let’s break down the individual factors:
Lower Tax Brackets
If you are in a lower tax bracket today than you expect to be in the future, a conversion may offer long-term tax savings. The difficulty with this is that we can’t possibly know future tax rates, especially if retirement is years or decades ahead. Some may opt for a Roth conversion simply because rates are currently low. For example, tax rates will jump across the board upon the expiration of the Tax Cut and Jobs Act at the end of 2025. But who is to say they won’t immediately go back down, perhaps even further?
Estate Planning
Roth IRAs and 401(K)s don’t have Required Minimum Distributions (RMDs), enabling you to leave a potentially hefty legacy to your heirs on a tax-free basis. Additionally, the funds in the Inherited Roth can continue to grow for another ten years until the recipient must remove them.
Tax Diversification
By converting a portion of your Traditional funds to Roth, you create the opportunity for a more nuanced tax strategy in retirement. This approach lets you balance withdrawals between your Traditional and Roth accounts, providing greater control over your taxable income. The result is the potential to maintain a lower tax bracket, optimizing your income in retirement.
Market Conditions
Roth conversions during market highs can be costly, resulting in increased tax liability and potentially higher penalties if you utilize funds from the Traditional account to cover the conversion taxes. Conversely, a market downturn may present an opportune moment to convert. This could lead to paying fewer taxes and may allow your funds to more easily recover to pre-conversion levels.
Break-Even Analysis
If you plan on using Roth funds for retirement but must pay your tax burden with converted funds, it’s important to calculate whether your funds will have ‘caught up’ by the time you need to withdraw them. Unfortunately, you may find that it’s simply too late to perform a conversion. Let’s use a simplified scenario to help understand the concept.
Imagine you’re considering converting funds from a Traditional IRA to a Roth IRA. To pay the taxes on the conversion, you plan to use some of the funds from the Roth itself. Since you’re under the age of 59½, this withdrawal will incur not only taxes but also a 10% penalty.
- Calculate the Initial Loss: Determine how much will be removed from the Roth to cover the taxes and penalties. This amount will reduce the funds available to grow within the Roth.
- Project Future Growth: Consider the expected growth rate for the remaining funds within the Roth and how much it would likely grow over your planned time frame.
- Consider Traditional IRA Growth: Compare this to the growth you would expect from leaving the funds in the Traditional IRA without converting, taking into account future taxes and Required Minimum Distributions.
- Identify the Break-Even Point: The break-even point is when the total value of the Roth (after paying taxes and penalties) catches up to what the value would have been if you had left the funds in the Traditional IRA.
- Evaluate Timing: If this break-even point is longer than your anticipated time until retirement or withdrawal, converting may not make sense. The longer time frame needed to break even might outweigh the potential future benefits of the Roth.
Other Factors
How to Pay for the Conversion
As previously mentioned, converting Traditional funds to Roth is a taxable event, meaning you will owe income taxes.
Utilizing Non-Retirement Funds
If possible, paying the tax with funds outside the retirement account keeps more money in your Roth account. However, not everyone has the funds required to pay the tax. You should also factor in what you would gain by simply investing those funds rather than using them to pay your tax obligation.
Avoiding Penalties
Alternatively, you can pay for your conversion by selling off assets in your Traditional or Roth accounts, though the rules will still apply. If you are under 59½, you could be penalized on the amount used to pay the taxes, so consider your payment strategy carefully.
Timing of Conversions
Timing can be vital in Roth conversions. To avoid pushing yourself into a higher tax bracket, you might consider staggering conversions over several years until you’ve converted the desired amount.
In Conclusion
Converting all or a portion of your Traditional retirement accounts can save you significant money on taxes over your lifetime. However, it may not make sense for your personal situation and goals. After factoring in the tax burden it entails, the amount of time required for your funds to catch up, legacy concerns, and market conditions, keeping your funds in a Traditional account may make more sense.
