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Roth IRA Conversions: Plan Ahead to Capture Big Benefits

Roth IRA Conversions: Plan Ahead to Capture Big Benefits

August 19, 2021

Roth IRA conversions have the potential to present big benefits in retirement planning, especially if you anticipate being in a higher tax bracket in retirement than you are now. However, this strategy may not be beneficial to everyone. So, before you decide to convert some or all the funds in your traditional IRA or 401(k) to a Roth account, you should have a basic understanding of how these transactions can impact your overall tax planning.

What Are Roth IRA Conversions?

To open and fund a Roth IRA in 2021, your modified adjusted gross income must be less than:

  • $208,000 if you’re married, filing jointly
  • $140,000 for singles or heads of households
  • $10,000 if you’re married, filing separate returns

If your income is above these amounts, you’re unable to open a Roth IRA. However, if you perform a Roth IRA conversion with funds in an existing IRA or 401(k)—you can bypass these income limitations and enjoy all the benefits Roth IRAs offer.

One reason people convert like this is to take advantage of the tax-free growth of earnings in Roth IRAs. This means distributions from Roth accounts are not taxed in retirement. That can make a big impact in your golden years.

But understand this—while this move can impact your annual tax burden in retirement, it will also impact your income level and tax burden in the year you convert, because you will owe tax on the amount you convert. Roth IRAs are funded with post-tax contributions. IRA and 401(k) contributions are made before tax. So, in order to convert those pre-tax funds, you must pay taxes on them.

Unique Features of Roth IRAs

There are many benefits Roth IRAs offer that other retirement accounts do not:

  • Once the Roth IRA is 5 or more years old, you can take penalty-free withdrawals of your initial

    contributions at any time, for any reason.

  • Distributions of earnings are tax-free when you reach the age of 59 1⁄2 and the account has been opened for 5 or more years.

  • There are no annual required minimum distributions (RMDs) in retirement like other plans have. You can leave all funds in a Roth IRA year after year, which allows additional wealth to grow.

  • You can continue to make contributions of annual earned income to Roth IRAs even after you reach retirement age.

  • Heirs of Roth IRAs do not pay tax on withdrawals provided they follow the rules for inherited Roth accounts.

Why Convert to a Roth IRA?

There are several reasons people perform conversions, and most expound on the features listed above.

RMDs from other IRAs are taxed as income when you take distributions in retirement. The amount of your RMD is based off the size of your IRA and your age. If you have accumulated great wealth in the account over the years, the amount of your RMDs can push you into a higher tax bracket than you anticipate. But remember, Roth accounts don’t impose RMDs—and distributions aren’t taxed anyway. So, when you do make withdrawals from a Roth, you won’t have to worry about it impacting your annual tax burden at all. Tax-free distributions from a Roth IRA can be a relief—creating confidence as well as lessening your annual income tax burden.

In legacy planning, inherited Roth IRAs enjoy tax-free withdrawals by your heirs. This can be especially beneficial for non-spousal heirs who now have only 10 years to deplete and close inherited IRAs. Distributions from inherited Roth accounts won’t drive your loved ones into higher tax brackets.

Also, when one spouse dies, the surviving spouse may possibly enter a higher tax bracket as a single filer than when they were married filing jointly. Creating a bit of tax-free income from a Roth IRA can be a great help for your spouse when you’re gone.

Should You Convert to a Roth IRA This Year?

While we can’t give you advice, we can give you something to consider. You must understand that when you perform a conversion, you must pay taxes on the funds you convert in the year you make the conversion. And, depending on your financial position, it may make sense for you to pay taxes on that money now instead of later in retirement.

In light of potential tax changes we may see by year’s end, a conversion this year may be favorable, especially if you’re in the high tier bracket that may bear the brunt of the proposed increased annual taxation by 2022. While you will have to pay taxes on the funds you convert in the year you make the conversion, it may make sense for you to pay taxes on that money now instead of later in retirement. Current tax rates are considerably lower right now, so a conversion this year could save you a significant amount of money in taxes you’ll owe on that conversion.

Make Sure It Makes Sense for You to Convert

Even though you can capture big benefits with a Roth IRA conversion, this move isn’t for everyone. Remember, you’re converting funds from a pre-tax account into a post-tax account. The money in your traditional IRA or 401(k) has not been taxed. But the money you convert will be subject to tax the minute you convert. It’s worth noting that it’s best to pay that tax from another resource than your IRA funds. You don’t want to deplete your retirement funds, and you also don’t want to incur an early-withdrawal penalty—and you will—if you pay tax with funds from your retirement account. There are additional reasons why converting to a Roth account may not be beneficial within your retirement planning. Discuss your thoughts and situation with your tax professional or financial planner so they can help you work toward what’s best for you.