Roth Conversion – When and How to Plan

If you have a traditional IRA, you may be considering a Roth conversion. There are many reasons why a Roth might suit your money better than a traditional IRA, however, knowing the differences between the two and the long-term results of moving your money can help you decide which IRA to choose.

Roth IRAs and conversions are a popular topic for those approaching retirement, so in this post, we explain why a Roth IRA might be beneficial to you, when to do a Roth conversion, and what’s involved in the process. 

The differences between a Roth IRA and a traditional IRA

An IRA, or Individual Retirement Account, allows you to save for your retirement through tax-free growth or on a tax-deferred basis. There are several different types of IRA, but the two most common we see compared are Roth and traditional accounts.

If you have a traditional IRA, you typically receive an immediate tax benefit after you’ve contributed. You put your money in pre-tax, and it will grow tax-deferred. This means that when you begin withdrawing money from the IRA, it’s treated as income and is taxable.

If you have a Roth IRA, you don’t get any immediate tax benefits after contributing. You put your money in after-tax, however, it grows tax-free within the Roth account and remains tax-free after you withdraw it.

So, if you’re looking at making substantial or long-term contributions to an IRA, a Roth account could be a better option for you. This way, you’ll pay less tax in the long run, as you won’t have to pay any tax on your savings growth.

But if you’d prefer immediate tax benefits, then a traditional IRA could be the better choice. So which IRA is best for you depends on whether you’d like your tax benefits now or in the future.

How RMDs affect traditional IRAs 

One thing to bear in mind with traditional IRAs is that you have to take an RMD (required minimum distribution) from the age of 72 and every year after.

This is the deal you make with traditional IRAs. While you receive immediate tax benefits when you make contributions, RMDs are the government's way of ensuring that they still receive tax revenue. RMDs are not optional, and you have to take them every year even if you don’t need the money.

RMDs are also taxed at future tax rates. If you believe that tax rates will be lower in the future, then a traditional IRA may make more sense for you. However, if you think that they will be higher, you might want to consider a Roth IRA.

A Roth IRA has no RMDs. You can withdraw as much or as little as you like, and you won’t be taxed on any withdrawals. 

Why contribution limitations can lead to conversions

There are contribution limits to both Roth and traditional IRAs, but for Roth IRAs there are also income limitations. If you earn too much, then you cannot make a direct contribution to your Roth IRA.

This is where a Roth conversion can help.

A Roth conversion is where you transfer money from your traditional IRA into your Roth IRA. One important thing to remember when you do this is that you have to pay tax on that asset. As the money will have gone into your traditional IRA pre-tax, you must pay tax on it before you can put it into your Roth IRA.

Once your money is in the Roth account, it can continue to grow tax-free for however long it’s in there. There are no requirements for when you should start taking money out or how much you should take out annually.

If you are taking RMDs from your traditional IRA, it’s important to know that you cannot convert them into a Roth account. The only way to move your RMDs into a Roth account is to combine it with an additional amount first. For example, if your RMD is $15,000 and you want to move this into your Roth account, you’ll have to take out more from your traditional IRA, say an extra $15,000, and move both amounts into the Roth account.

You can contribute to your IRA account when you file your taxes. For most people this is usually around April. But conversions must be done by the end of the year. The deadline for Roth conversions is December 31st.

Why should you do a Roth conversion

Roth conversions make a lot of financial sense when you’re temporarily in a low tax bracket or receiving very little taxable income. If you’re in a situation where you’re expecting your tax bracket to rise or your taxable income to increase, then it’s best to do a Roth conversion as soon as possible.

Converting at a time when you pay less tax has the best long-term benefits for your money as it will continue to grow tax-free and you’ll never have to pay tax on it again. This is the number one reason that many people do a Roth conversion.

The second reason is that you want to avoid RMDs. If you’re planning long term, then you could aim to convert all of your money from your traditional IRA before you turn 72. This way you won’t have to take RMDs and pay tax on them. Even if it’s not possible to convert all of your money before then, by moving some money into a Roth account, your RMDs could decrease and you’ll pay less tax overall.

The step-by-step process of a Roth conversion

If you’re thinking about doing a Roth conversion, the first step is to speak to a financial advisor. We can help you look at the whole picture and gauge whether it makes sense for your money.

We take a look at your current tax bracket, what future tax brackets we can expect, and if it’s the best year to make this type of conversion. We also involve CPAs who can help us decide how much to convert and navigate tax brackets.

Speaking to a financial advisor will also help you determine what your goals are for your money. We’ll help you understand why a Roth conversion may or may not help you reach those goals, and then once you’re happy, the process is as simple as moving money from one account to another.

So, if you’re considering a Roth conversion or have any questions about IRAs and what they can do for you, then reach out to us. You can book a complimentary 15-minute call with a member of our team to discuss which avenue is right for you. Book your call today to get started!