October 30, 2023 Weekly Update

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We do love it when someone refers a family member or friend to us.  Sometimes the question is, “How can we introduce them to you?”   Well, there are multiple ways but a very easy way is to simply forward them a link to this webpage.

Here are this week’s items:

Portfolio Update:  Murs and I have recorded our portfolio update for October 30, 2023

CLICK HERE TO WATCH THE UPDATE

Roth IRA – 5-Year Rule – Your Retirement – Part 2 with Denise Appleby

Denise Appleby explains the nuances around two separate Roth IRA 5-year rules and what you need to take distributions from a Roth IRA if you’re aged 59 and a half or below. Listen in to learn the importance of starting your Roth IRA 5-year clock earlier and protecting your records to avoid paying taxes you don’t owe.

CLICK HERE TO LISTEN TO THE PODCAST

 

CLICK HERE TO WATCH ON YOUTUBE

Roth IRA – 5-Year Rule – Part 2 with Denise Appleby

In our last podcast (read the blog here), we dove right into one of the most common questions our clients and listeners have: Roth IRAs and the 5-year rule. Well, we decided that we need to cover this topic even more in-depth and brought Denise Appleby on the show to clear up any confusion that you may have.

CLICK HERE TO READ THE BLOG

Roth IRA – 5-Year Rule – Part 2 with Denise Appleby

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In our last podcast (read the blog here), we dove right into one of the most common questions our clients and listeners have: Roth IRAs and the 5-year rule. Well, we decided that we need to cover this topic even more in-depth and brought Denise Appleby on the show to clear up any confusion that you may have.

Denise is an expert in all things IRAs and an excellent consultant for these types of questions.

What are the 5-Year Rules?

Denise was quick to point out that it’s not the 5-year rule but the 5-year rules. Two main rules are in place and the challenge is determining which rule applies to you.

First 5-Year Rule

This rule is used to determine if a Roth IRA distribution is qualified. This rule starts January 1 on the first year that you fund your Roth IRA, and it never starts over.

For example:

  • 2010, you contribute to a Roth IRA
  • 2023, you start a new Roth IRA because you cleared out the original
  • When did the 5-year period start? January 1, 2010.

Second 5-Year Rule

The second 5-year rule only pertains to you if you’re not eligible for a qualified distribution. Under this rule, we’re looking at Roth conversions and their distributions. If you withdraw the money that you put in within the first 5 years, you’re subject to a 10% distribution penalty.

However, the rule is very complex because it starts over with each conversion.

For example:

  • In 2020, you perform a Roth conversion
  • You take a distribution in 2023

The distribution would come from the 2020 conversion first before any conversion you do at a later date, if that applies.

This rule can be very hard to wrap your head around without an example.

Whose Responsibility Is It to Track Distributions and the 5-Year Rule?

Each conversion you make has a 5-year rule attached to it. Unfortunately, it’s your responsibility to track these conversions and how long ago they were made. For example, let’s assume that you convert $10,000 over the next 5 years.

The IRA custodian will not track these conversions. The IRS says that if a distribution is made and the IRA custodian doesn’t know the following, the custodian will report it as a non-qualified distribution without an exception:

  • If the person is eligible for an exception, or
  • If the person is eligible for a qualified distribution

It’s your burden to provide your tax preparer with the documentation necessary to show that the distributions are penalty-free. You can do this by keeping documents handy, such as your Form 5498.

You must protect yourself by keeping clear documentation of conversions. If you don’t keep proper records, you’ll pay penalties because there’s no proof that the distributions are non-qualified.

As you can see, there are a few nuances around the 5-year rule that can be complex and a bit tricky. Part of the reason why we’re diving deep into this rule for retirement planning is that you can leverage conversions now for tax planning purposes.

We know that unless there are significant legislative changes made before 2026, tax rates are going to go up.

Converting traditional IRAs to Roth accounts now may be beneficial for you and allow your money to grow tax-free. Most of our clients are doing conversions for future potential use way down the road or they’re doing it for their legacy. In these cases, the 5-year rule won’t matter to them.

With this in mind, let’s consider the following example:

Example 1: 60 Year Old with a Roth Balance of $100,000 that is Well Past the 5-Year Rule

If this person did a conversion last year of $100,000, do they have to wait five years to take distributions on this conversion? No. Because they are over the age 59 and a half, the second 5-year rule does not apply, and they can take a distribution without additional tax or penalty.

Anyone over age 59 and a half doesn’t need to track anything aside from having had a Roth account open for at least 5 years. You’re in a very nice place to be at age 60.

Because of this, we recommend that you establish a Roth account, even with a small contribution, as soon as possible. Why? Your five-year period starts ticking down the moment that the account opens. You could potentially not contribute to the account for years, but that five-year period will be ticking down, allowing you the freedom to do conversions in the future and still take distributions from the account without penalties.

Example 2: 50 Year Old, No Roth Account and Has Opportunity to Do a Roth Conversion

Imagine that this individual begins converting their accounts and assumes that they’ll wait until they’re at least 59 and a half to begin distributions. Life happens, and suddenly, the person does need to take money out of the account before then.

If they haven’t had the Roth IRA for 5 years and aren’t eligible for a distribution, then we need to look next at the ordering rules.

What are Ordering Rules?

Ordering rules pertain to your Roth IRA and distributions. Your distribution is taken from your account in the following levels:

  1. Regular Roth IRA contributions or money rolled over from Roth 401(k), 403(b), 457(b). These contributions come out first and are always tax- and penalty-free.
  2. Conversions from traditional SEPs and SIMPLEs and rollovers from the pre-tax side of 401(k) plans. Unless you qualify for an exception, these distributions will have a 10% penalty because of your age and not meeting the 5-year rule. What are the exceptions? If you converted the account at least 5 years prior, you could take distributions without penalty.
  3. Earnings, which are taxable and subject to the 10% penalty.

If you must take distributions early, you want to avoid taking money from levels 2 and 3. Level 2 money still has the 10% penalty unless you fall under very specific circumstances, and level 3 money is both taxable and comes with a penalty.

Example 3: 50 Year Old with Plans to Convert $10,000 Each Year Until 60, Never Had a Roth Before

Over the 10 years, the person has $100,000 in conversions in the account. The account has been open for five years, so one rule is checked off. The person is also 60, so they can start taking qualified distributions if they wish. Any distribution going forward is both tax-free and penalty-free. They can tap into growth without penalty as well. 

Legislatively, everything is always up in the air. Ages can change for these rules. A few years ago, the government did try to make changes to some Roth provisions, but they haven’t tried to do so recently.

Even the Secure Act 2.0 was very Roth-friendly.

Denise does not believe that Roth accounts are going anywhere any time soon because the IRS wants to be paid upfront. The IRS always wants to be paid as soon as possible, so it’s not likely that Roth accounts will be a major legislative target at this time.

Of course, things can change and new rules can be added, but we’ll keep you up to date on these occurrences.

Does a Roth 401(k) Start the 5-Year Clock?

No. A Roth 401(k) does not start the Roth IRA clock. The time that you’ve had the 401(k) open doesn’t apply to your IRA, which is very unfortunate.

What Should People Think About When It Comes to the 5-Year Rule?

Final points from Denise:

  • Having and contributing to Roth 401(k) is not the same as opening and contributing to a Roth IRA.
  • If a spouse beneficiary inherits a Roth IRA and the spouse treats it as their own, the 5-year period is considered to have begun at the earlier of the two spouse’s first Roth IRA contributions. However, if the funds are transferred to a beneficiary IRA, the accounts inherit the decedent’s period. Do you have documentation on these accounts?
  • Beneficiary IRA accounts allow for $10,000 to be used for a first-time home purchase without penalties.

Clearly, there is quite a lot to think about with Roth IRAs, conversions and the 5-year rule. Having an expert like Denise at your side is extremely beneficial when working on these accounts.

If you have any questions, you can schedule a free 15 minute call with us and we’ll be more than happy to have a conversation with you. We can even consult Denise on any complex questions.

October 23, 2023 Weekly Update

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We do love it when someone refers a family member or friend to us.  Sometimes the question is, “How can we introduce them to you?”   Well, there are multiple ways but a very easy way is to simply forward them a link to this webpage.

Here are this week’s items:

Portfolio Update:  Murs and I have recorded our portfolio update for October 23, 2023

CLICK HERE TO WATCH THE UPDATE

This Week’s Podcast – Roth IRAs – 5-Year Rule and Conversions in Retirement

Listen in to learn the difference between Roth IRAs’ contributions and conversions and how the 5-year rule applies to each. You will also learn about the five advantages of a Roth IRA: tax-free growth, not subject to RMDs, tax diversification, estate planning benefits, and hedge against future tax increases.

CLICK HERE TO LISTEN TO THE PODCAST

 

CLICK HERE TO WATCH ON YOUTUBE

This Week’s Blog – Roth IRAs – 5-Year Rule and Conversions

Roth IRAs are on the minds of many of our clients and listeners. If you’re concerned that taxes may be higher in the future, you may want to learn more about Roth Accounts. In a Roth account, you pay taxes on the money today and can then allow it to grow tax-free. However, you also need to be aware of the 5-year rule for Roth IRA conversions. The rule is a small caveat that is easy to overlook…

CLICK HERE TO READ THE BLOG

Roth IRAs – 5-Year Rule and Conversions

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Roth IRAs are on the minds of many of our clients and listeners. If you’re concerned that taxes may be higher in the future, you may want to learn more about Roth Accounts. In a Roth account, you pay taxes on the money today and can then allow it to grow tax-free.

However, you also need to be aware of the 5-year rule for Roth IRA conversions. The rule is a small caveat that is easy to overlook, but it impacts your ability to withdraw your earnings without penalties or taxes.

5-Year Rule for Roth IRA Contribution: Limits and Requirements

You can contribute to a Roth, but there is an income level that you need to be concerned about. We won’t go into these levels in great detail, but a lot of companies are offering Roth 401(k) options to circumvent these income limits – just a contribution limit.

If you contribute money into a traditional Roth IRA, it’s 100% liquid. You can put $10,000 in and take it right back out of the account.

However, the 5-year rule pertains to the interest earned on the account.

Example 1: the 59 ½ Rule

For example, let’s say that I’m 40 years old and I put $10,000 into a Roth IRA. Fast-forward 10 years. Now I’m 50 years old, and the $10,000 I put into the account has swelled to $20,000. You’re past the 5-year rule, but you’re not 59 1/2 yet.

You can take out the $10,000 that you put into the account without penalties, but you cannot touch the interest until you reach the 59 1/2 threshold.

Example 2: the 5-year Rule

Since many of our listeners and clients are past the 59 1/2 age requirement, let’s look at another example of someone who is 60 and contributes to a new Roth IRA. In four years, they gain $3,000 – $4,000 in interest, but since it’s a new Roth, they cannot take the interest out with a penalty based on the 5-year rule.

So, the 5-year rule for a new Roth IRA account has two main components:

  1. 59 1/2 years of age to touch the interest
  2. 5 years to take out the interest without 10% tax penalty and paying taxes on the interest

Even if you’re 65 and just opened the account, you still need to wait five years before you can touch the interest without being concerned about penalties or taxes.

Note: Contributions into Roth IRAs are always penalty-free, as you’ve already paid taxes on the money.

5-Year Rule for Roth IRA Conversions

Conversions and contributions are different. A Roth conversion is not subject to limits, so if you have pre-taxed assets, you can convert $1 million (or whatever amount you like). Let’s say that you have a traditional IRA. You can convert 100% of the account if you like.

However, you will need to pay taxes today on the money that you’re converting into the Roth IRA to leverage this tax-free bucket.

How Does the 5-Year Rule Impact Roth IRA Conversions?

Roth conversions are very powerful and beneficial because your money can grow tax-free. The rules on these conversions are different, so let’s look at an example:

  • This person is 60 years of age
  • $1 million in pre-tax IRA
  • $100,000 converted into a Roth IRA
  • **This is the first time the person opened a Roth IRA

The person is above the age of 59 1/2, so they meet this threshold for taking money out of the account without penalties. However, since this is the first time the person has had a Roth IRA account, they must wait five years before being able to withdraw on the tax-free growth.

Let’s say that if the person comes back in two years and wants to take out $30,000 for a new roof, they can do so because they’re not touching the tax-free growth on the account.

If you’re under the age of 59 1/2 or fall into one of the following categories, there are some exceptions:

  • Disability
  • First-time homebuyer
  • Deceased 

Pro Tips: The clock starts ticking from the moment you open the account. Let’s say that you did a conversion at 55 and a conversion at 60. You don’t need to worry about the 5-year rule. We recommend converting even a small amount into a Roth IRA to get the clock started so that the account is open for 5 years.

Note: Always be sure to consult with a financial advisor before making any distributions to ensure that you follow all the rules and regulations.

Click here to schedule a call with us to discuss your Roth conversions, contributions, or distributions.

Example of the Power of Roth IRA Conversions

In this example, let’s say you’re 60 years old and opening a brand-new Roth account to start doing $50,000 into conversions per year for 5 years. We’re not worried about the 59 1/2 age rule, and we estimate that the account will earn 5% compound interest annually.

Year 1: Conversion of $50,000 + 5% interest ($2,500) = $52,500 total
Year 2: Conversion of $50,000 + 5% interest on ($52,500 + 50,000 = $5,125 = $107,625 total
Year 3: Conversion of $50,000 + 5% interest on ($107,625 + 50,000) = $7,881.25 = $165,506.25 total
Year 4: Conversion of $50,000 + 5% interest on ($165,506.25 + 50,000) = $10,775.31 = $226,281.56 total
Year 5: Conversion of $50,000 + 5% interest on ($226,281.56 + 50,000 = $13,814.08 = $290,095.64 total

Cumulative growth on your money is very powerful. You’ve contributed $250,000 in conversions and earned over $40,000 in interest in just five years.

What happens if, in year four, you need to take a withdrawal?

At year 4, you have an account total of $226,281.56. How much can you take out of the account? You can take out $200,000 because those are your contributions. At the end of year 5, you have 100% access to the money because you hit all thresholds.

Walking you through some math, let’s assume that you don’t need the money and let the $290,095.64 sit for 15 years without any further conversions or contributions. 

Based on 5% interest per year, your $250,000 put into the account would now be $602,998.22.

You’ve earned over $350,000 in interest alone.

Now, you want to take out $350,000 and pay taxes on it. You would need to pay a huge chunk of money if you didn’t pay taxes already. However, since you did a conversion of $50,000 a year, you paid 22% in taxes or $11,000 in taxes per conversion.

You paid:

  • $55,000 in taxes total for all contributions
  • Gained $350,000 in interest that is 100% tax-free

You achieved great tax-free growth and can now withdraw the $350,000 in its entirety.

With that said, Roth IRAs have their advantages and disadvantages.

Advantages of a Roth Conversion

Roth accounts are one of our favorites and we like them so much because of how advantageous they are. You benefit from:

  1. Tax-free growth that grows over time.
  2. Not subject to required minimum distributions. Unlike a 401(k) or other pre-tax accounts, you don’t need to take a required minimum distribution (RMD) on the account. You can keep the money in the Roth for as long as you wish, allowing you to be in more control.
  3. Tax diversification because you have a sizeable tax-free asset. You can blend withdrawal strategies using taxable and non-taxable accounts to minimize taxes.
  4. Estate planning benefits also exist. You can pass the account to your heirs, who can take tax-free distributions over their lifetime. Beneficiaries must withdraw the entire account over 10 years and can allow it to remain in the account for 10 years and still don’t need to pay taxes on the growth.
  5. Hedge against future tax rates because this tax-free bucket will not be subject to higher taxes, which we’re very likely to see in 2026 unless major legislation is otherwise passed.

Disadvantages of a Roth Conversion

While we’re major fans of Roth IRAs for retirement planning, Roth conversions are not ideal for everyone. These disadvantages are things you should keep in mind.

  1. Immediate tax burden. You will need to pay taxes on the conversion, which no one likes. But you benefit from the money growing tax-free.
  2. Potential of lost tax benefit. If you’re at a higher tax bracket today but in the future taxes are lower, you lose the benefit of lower taxes. We don’t know what the tax rate will be in 10, 15, or 20 years from now.
  3. Loss of liquidity. You lose some liquidity with your money because, in many cases, you’ll use outside funds to fund the account, such as cash.
  4. 5-year rule. Of course, you do have to wait 5 years to touch any of the interest in the account.
  5. Potential impact on other benefits. If you’re about to convert at Medicare age, you may have to pay an IRMAA surcharge for a single year of the conversion. 

If you’re looking at this and have questions, it is very overwhelming. However, you can always schedule a call with us right on our website to go over this information in greater detail.

Click here to schedule your call.

June 20, 2023 Weekly Update

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We do love it when someone refers a family member or friend to us.  Sometimes the question is, “How can we introduce them to you?”   Well, there are multiple ways but a very easy way is to simply forward them a link to this webpage.

Here are this week’s items:

Portfolio Update:  Murs and I have recorded our portfolio update for June 20, 2023

CLICK HERE TO WATCH THE UPDATE

This Week’s Podcast – Mid-Year Tax Planning – Why So Important in Retirement?

It’s important to look at the previous year’s tax situation because some things, like Roth conversions and qualified charitable distributions, need to be done before the end of the year in order to be reported on your tax returns.

Listen in to learn the importance of coming up with a good tax withholding strategy to avoid tax liabilities and bills during tax season. You will also learn about the tax benefits of donor-advised funds and qualified charitable distributions.

CLICK HERE TO LISTEN TO THE PODCAST

 

CLICK HERE TO WATCH ON YOUTUBE

This Week’s Blog – Mid-Year Tax Planning – Why So Important?

Why are we talking about tax planning in the middle of the year? Mid-year tax planning allows you to get everything in order before the end of the year to lower your tax obligation as much as possible.

In June of 2023, we’re doing a lot of work to get ready for our tax planning and strategy meetings we’ll be having later this year. A lot of prep work goes into these meetings because it’s one of the most intense that we’ll have all year.

CLICK HERE TO READ THE BLOG

Mid-Year Tax Planning – Why is it So Important?

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Why are we talking about tax planning in the middle of the year? Mid-year tax planning allows you to get everything in order before the end of the year to lower your tax obligation as much as possible.

Note: We are not giving specific advice. We’re talking in general terms and advise you to discuss your own tax planning with a professional who can recommend the best method to reduce your tax burden.

In our most recent podcast (listen to it here), we have two members of our team with us, Nick Hymanson, CFP® and Taylor Wolverton. 

In June of 2023, we’re doing a lot of work to get ready for our tax planning and strategy meetings we’ll be having later this year. A lot of prep work goes into these meetings because it’s one of the most intense that we’ll have all year.

Why Do We Do Tax Planning and Tax Strategy Before the Beginning of the Year?

First, we want to review your tax situation from last year so we can understand potential moves we can make before the end of this year.

For example, Roth conversions or qualified charitable distributions (QCDs) need to be made before the end of the year to be reported on your tax return. Changes to your contributions or account conversions must be completed before December 31st of the year to be claimed on your taxes.

Mid-year tax planning helps us get everything in order to have a discussion with our clients on which strategies we can employ to lower your tax burden.

How Financial Planning Ties into Tax Planning

Financial, tax, and retirement planning are all linked together, or they should be if they’re done professionally. We have clients who first retire and live on cash in the bank, and then they start taking money from an IRA or a required minimum distribution.

In our process, at the beginning of the year, we have a financial planning meeting to update where their income is coming in this year, and we review what happened in 2022 (or the year prior).

From an income perspective, we want to understand where your income came from last year. We want to understand any unique changes that may have transpired this year and your income last year.

During the year, you may have income coming in from multiple sources, and it’s crucial that you have a good tax withholding strategy in place.

Proper tax withholding will allow you to avoid any unexpected tax surprises the following year. Having conversations throughout the year allows us to position our clients to pay less taxes by making smart financial decisions.

For example, if you want to sell a highly appreciated stock, we may recommend holding off until the beginning of the coming year because there are tax advantages.

We perform a full software analysis of our clients’ past year taxes to look for:

  • Filing status
  • Social Security number accuracy
  • Sources of income (interest, dividends, etc)
  • Withholdings 

We look through all these figures with our clients to help you better understand the tax obligations of each form of income. If you want to adjust your withholdings or make income changes, we’ll walk you through this process.

For example, you may not want a refund at the end of the year and want to withhold just enough taxes to be tax-neutral. You won’t pay or receive anything at the end of the year from the IRS.

With a mid-year tax plan, we have a better understanding of the steps that must be taken to reach your goals in the coming year.

Things to Do Before December 31st

Retirees must do a few things before the end of the year by law. Here’s what you need to know:

Donor-advised Funds

Sometimes we learn from a tax return or through a conversation with our clients that they give $10,000 to charity per year. Can you itemize? Sure, but the standard deduction is so high that it often doesn’t make sense to do this.

What’s the Standard Deduction

For your reference, the standard deduction in 2023 is:

  • Single: $13,850
  • Married filing jointly: $27,700 (65+ goes up by $1,500 per spouse)

Itemization won’t make sense if you have less than the standard deduction amount in contributions.

If you do a donor-advised fund, you can stack charitable contributions and use the multi-year contributions as a deduction this year.

Let’s assume that you put $40,000 into a donor-advised fund. You can still make $10,000 contributions to your favorite charity, but you can then take a $40,000 deduction this year to negate your tax burden. Itemizing is the best course of action if you have more deductions than the current standard deduction amount.

We may recommend this strategy if you expect a very high tax burden and want to lower your tax obligation.

Opening a Donor-advised Fund

We use Charles Schwab for our funds, but you can use a custodian of your choosing. A donor-advised fund looks just like any other account held at Charles Schwab, except for a few differences. Checks are written directly to a Schwab charitable account and funds are held directly in this charitable account. You can assign contributions to charities of your choice.

Funds remain in the account and can be withdrawn and moved to the charities in the future. Once you put money into the fund, you cannot reclaim it in the future. You can decide annually on who you want to distribute contributions to.

However, it is very important that Charles Schwab has information on the charity that you want to disperse the money to and that everything is in order for the distribution to be made problem-free.

Qualified Charitable Distribution

Qualified charitable distributions (QCDs) are another tactic that you can use if you’re over the age of 70-and-a-half. Age requirements and the time of your distribution are crucial and one of the reasons that people often work with a financial planner.

We can make sure that you’re making the QCD properly and get all the tax benefits that go along with it.

Note. If you have a required minimum distribution (RMD), you can set up the QCD to be taken directly from this. A key benefit is that if the RMD never hits your bank account, you don’t have to pay taxes on it.

Making Out Your QCD Check

In terms of Charles Schwab, we want to make sure that the QCD check is made out directly to the charity and not the account owner. If the check is written to the tax owner, it is considered taxable income.

We need a few things when writing out the QCD check:

  • Name of charity
  • Charity’s tax ID
  • Charity address
  • QCD amount

One important thing to note is that there’s an option to send the check directly to the charity or to the account owner, who can then hand-deliver the check to the charity.

The most important thing is to have the check written to the charity itself with the tax ID.

What You Need to Gather for a Tax Planning Strategy Meeting

Whether you work with us or someone else on a tax planning strategy meeting, you’ll need a few documents to get started:

  • Last year’s tax returns
  • Income for the coming year
  • Changes to income in this year
  • Change to cost of living on Social Security

We really need to know your sources of income and if any changes to this income have occurred in the last year. Cost of living adjustments are a big one and will impact your taxes, but all of this is information necessary for a tax planning strategy meeting.

IRMAA is another thing that we want to consider, and we have a great guide on the topic, which you can read here: IRMAA Medicare Surcharges.

Medicare looks back two years to determine your surcharges, which is something we can plan for with enough time and a strategy in place. We want to manage your Medicare surcharges so that you don’t need to pay more than necessary for your Medicare.

Tax strategy can help you better prepare for your taxes and make strategic moves that will save you a lot of money in the future.

We have a team of people working with us to handle all these moving parts and walk our clients through the process.

Want to learn more about retirement planning?

Click here to view our latest book titled: Secure Your Retirement.

How to Convert an IRA to a Roth IRA

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Is a Roth conversion right for you?

Moving your money from a traditional IRA or 401k and into a Roth IRA can be a smart choice for your future finances. But, while the mechanics of a Roth conversion are simple, it’s important to get the full picture to find out if it will benefit you in the long term.

In this post, we share everything you need to know about doing a Roth conversion, including what a Roth conversion is, why you may choose to do one, and the process of moving your money between these two different types of accounts.

You can watch the video on this topic above. To listen to the podcast episode, hit play below, or read on for more…

The differences between a traditional IRA and a Roth IRA

A traditional IRA or 401k is considered pre-tax money. It gives you an immediate tax benefit. So, for example, you may be using salary deferrals to contribute to a 401k which automatically comes off your income for the year. When you withdraw from a traditional IRA, then the money becomes taxable, similar to a paycheck.

A Roth IRA contains after-tax dollars, but it grows tax-free, and you won’t be taxed when you withdraw it. Say you contribute $50,000 to a Roth IRA that’s invested in the market, and it grows to $100,000 or even $200,000. You can withdraw this without being taxed.

So, these are the two key differences:

  • Traditional IRAs and 401ks are pre-tax (but you’ll pay tax on withdrawal)
  • Roth IRAs use after-tax money (but you get a tax benefit later)

One thing that is the same between the two accounts is how you invest. You can invest both a traditional IRA and Roth IRA exactly the same.

How much of a traditional IRA can you convert to a Roth IRA?

Broadly speaking, you can convert 100% of your traditional IRA or 401k into a Roth IRA. There are no conversion limits. So, if you have $1 million in your traditional IRA, you can convert the entire $1 million into a Roth IRA.

But don’t get conversion and contributions mixed up. There are contribution limitations. However, these depend on your age and income.

How to convert your traditional IRA into a Roth IRA

Converting your traditional IRA into a Roth IRA is a simple process, similar to switching any account. The easiest way to do a Roth conversion is when both IRAs are held at the same institution.

For example, if you had a traditional IRA at Charles Schwab and wanted to do a Roth conversion, the easiest option is to open a Roth IRA also at Charles Schwab. Then it’s a straightforward transfer to move your money from your traditional account into your Roth account. You just have to know how much you want to convert, then sign the document and the custodian (in this case Charles Schwab) will take care of the rest.

If your traditional IRA and Roth IRA accounts aren’t held at the same institution, the process is almost the same, but with a few extra steps. It’s best to check with your traditional IRA or 401k account holder to find out what their exact process is, and they’ll help you through it.

Taxes: what to look out for when converting

When you do a Roth conversion, you have to pay taxes as you’re moving money out of a pre-tax account and into an account for after-tax dollars only.

You might consider holding back some money to cover these taxes. However, we believe this isn’t the best option. You may not be able to make contributions to your Roth IRA, so a conversion is the only way to put as much money as you can in this tax-free account. So, we advise converting 100% of your traditional IRA into a Roth IRA and paying the taxes from another account, such as savings or a brokerage account.

Say you want to convert $30,000 from your traditional IRA into a Roth IRA. First, you should make sure you have enough money outside of your traditional IRA to cover the taxes. On $30,000, these taxes may equate to around $6,000. If you decide to take that $6,000 from your IRA money, you’re putting yourself at a long-term disadvantage. The tax-free growth of a Roth IRA means you should put as much money in as possible to reap the future benefits.

Depending on your tax situation, you may need to think strategically about how much you can convert. You don’t want to end up in a higher tax bracket because you converted too many extra dollars. If you’re unsure about how much you can convert without changing your tax bracket, speak to your financial planner or advisor who can help you play with the numbers.

Why you need to consider future tax

The number one reason to do a Roth conversion is to protect against higher tax rates in future. The idea is to pay lower tax rates now and avoid rising ones later down the line. So, if you believe that your taxes will be lower in future, a Roth IRA will not make sense for you.

If you currently have a high-income rate, say $250,000, but are expecting this to drop to $60,000 in 15-20 years, then you could be paying less tax in future. However, if tax rates rise, you may pay a higher percentage, even though you’re earning a lower amount. So, the question is, would you still convert?

In this situation, one solution is to do smaller conversions and split your money into both pre-tax and after-tax assets. Ultimately, we don’t know what might happen in the future, so you will need to think carefully about whether a conversion is really right for you and put a strategy in place.

How to avoid required minimum distributions with a Roth conversion

Any pre-tax account, including traditional IRAs, 401ks, and 403bs, are subject to required minimum distributions (RMDs). These are to make sure that you do eventually pay tax on this money. At age 72, you’ll be required to take withdrawals from your pre-tax account based on your life expectancy.

Another reason many people choose to do a Roth conversion is to avoid these RMDs. You may prefer to pay your taxes now rather than on RMDs at age 72. If you’re already at this age, it becomes more challenging to do a Roth conversion as the IRS requires you to take the RMDs every year.

Say you have $1 million in a traditional IRA and your RMD for that year is $50,000. If you want to do a Roth conversion, you have to take the $50,000, put it in your bank, pay the taxes on it, and only then can you proceed with the Roth conversion. So, if you wanted to convert $20,000 from your traditional IRA into a Roth IRA, you could do this after you’ve taken and paid tax on your RMD. It’s important to note that this means you’ll have to pay tax on both amounts, so $70,000 in total that’s been added to your income for the year.

Our advice is, if you’re planning to do a Roth conversion, don’t wait until you’re RMD age.

It’s important to look at the whole picture when deciding whether to do a Roth conversion. Tax numbers can be confusing, so it’s best to find out what solution suits your specific situation. If you want to get more insight on converting your traditional IRA into a Roth IRA, you can book a complimentary 15-minute call with us and we’ll discuss what option is right for you.