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.

How Are You Going to Stay on Top of Your Finances in 2021?

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How are you going to stay on top of your finances in 2021?

Financially planning for retirement can feel like a lot of work, especially if you have multiple moving parts to your money. Dealing with 401Ks, IRAs, Social Security, and RMDs can become overwhelming as the year gets busier, so we recommend taking stock of your finances early and planning ahead.

The beginning of the year is a great time to review your finances but knowing where to start is challenging. So, we’ve created our retirement and financial planning checklist.

Read on to discover the nine key areas you should consider for the upcoming year. We also point out some key changes and information for 2021, so you can start this year as securely as possible.

1. Review your 401K, traditional IRA, Roth IRA, and HSA contributions

If you’re earning income, you should review your accounts and plan how much you want to contribute to each one this year. Do you have a goal for each? How much will you need to contribute to get you there?

Bear in mind that contributions may be limited, so you might need to adjust your plans and payroll accordingly. For example, the contribution limit for 401Ks in 2021 is $19,500. However, if you’re over 50 years of age, you can qualify for the ‘catch-up contribution’, increasing the $19,500 limit by an additional $6,500. This also applies to 403Bs and 457 plans.

Roth IRA accounts have a much lower contribution limit of $6,000, with an additional $1,000 for those over 50.

We’ve detailed the difference between Roth IRAs and traditional IRAs before, but to recap, the main differences are:

  • A Roth IRA is tax-free assets: contributed to after you’ve paid tax on the money – these have income limitations, so if you earn over a certain amount, you will not be able to contribute
  • A traditional IRA is pre-tax assets: contributed to before you’ve paid tax on the money – no income limitations

To learn more about the pros and cons of Roth IRAs vs traditional IRAs, read this post.

Once you are aware of your accounts’ limitations, we advise you plan your contributions for the year. This way, you can ensure you’re on track to achieving your long-term money goals without having to continually review your accounts’ statuses.

2. Update your beneficiaries

Life sometimes moves so fast that it can be hard to keep up. New grandchildren, marriages, or other life changes may affect who you want as a beneficiary.

It’s important to stay on top of your different accounts and which beneficiaries are associated with them. Your accounts and associated beneficiaries should align with your overall estate plan and life insurance to avoid confusion.

Updating beneficiaries can be easily done online or with a signature on a form. It should only take a few minutes and is something we highly recommend putting in order while you have the time.

3. Consolidate your accounts

If you’ve previously changed employment, you may well have more than one 401K plan open. We often speak to clients who have two, three, or four 401Ks with past employers, that they’ve completely forgotten about – and that have substantial balances in them!

Moving existing 401Ks into a traditional IRA is a fantastic way to consolidate your accounts. It’s completely tax-free, with no risk, penalties, and typically no fees. If you hold multiple traditional IRAs, we also advise consolidating these into just one account.

By reducing the number of unnecessary accounts, managing your money will become more straightforward and less stressful.

4. Assess your mortgage rate

It’s very unlikely that mortgage rates will reduce further, so we recommend taking advantage of them while you can. Now is a great time to refinance your house or any investment properties you have a loan on. An advantageous rate could lower your payments, giving you greater monthly cash flow, or help you pay off the loan faster.

We spoke to a Loan Officer with 15 years’ experience about the benefits of refinancing in our podcast episode ‘Tammi Rowe – Planning Your Mortgage and Retirement’. To find out more about what refinancing could do for you, listen to the episode.

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5. Plan for emergencies

You might be faced with a financial opportunity, for example, paying off your mortgage, but it’ll leave you with less cash in the bank than you’d like. Should you do it? Or should you build up your ‘emergency fund’ first?

Having cash reserves in case of emergencies is necessary. But you don’t always have to choose between keeping lots of cash in the bank or paying off a substantial loan.

One tip we give our clients is to open an equity line of credit. There can be a minimal fee to open it, but there’s no interest if you don’t have any balance. This means that if you spend your cash reserves on something like paying off a mortgage, you have easy access to cash, as an equity line of credit comes with either a debit card, a checkbook, or both.

An equity line of credit is only available to those still working, so if you want an emergency fund for the future, we urge you to set one up while you still qualify. You won’t need to make any payments, and it won’t gain any interest, so long as the balance is zero.

6. Consider how and when you’ll take your RMDs

If you’re turning 72 in 2021, pay close attention. RMDs or Required Minimum Distributions were optional in 2020, however, the rules are changing for 2021, and if you turn 72 this year, you will have to take your RMDs this year and every year going forward.

Your individual RMDs are based on your IRAs’ combined balance, so there isn’t one set figure for everyone. You can spend your RMDs, or you can reinvest them into another brokerage account, but they must leave your IRA and cannot go into another IRA.

Bear in mind that money in a traditional IRA is pre-tax. So, when it leaves the IRA as an RMD, it’s treated as income and will be taxed.

There is no rule when you should take your RMDs, but you must start taking them before December 31st from the year you turn 72. Some people choose to take it monthly, like a paycheck, and others take it as a lump sum at the beginning or end of the year.

If you don’t need to take your RMD and don’t want to pay tax on the money you don’t need, you can make a qualified charitable deduction once you’re aged 70 and a half. This is where you direct your RMD straight from your IRA to a charity of your choice. This way, your RMD leaves the IRA but isn’t claimed as income, making it tax-free.

You can also do this with a portion of your RMD. For example, if your RMD is $10,000, and you want to instruct $5,000 to a charity and keep $5,000 for yourself, you only have to pay tax on the $5,000 you keep.

7. Apply for Social Security

If you’re planning on taking Social Security in 2021, it can be a long process. Right now, there are thousands of people applying every single day, so we advise applying two to three months ahead of when you want to start receiving your Social Security benefits.

You can apply as early as three months before the date that you want to start receiving them, so if you’ve already decided it’s part of your financial plan for 2021, don’t wait. Plan ahead, make the phone calls, and fill out the paperwork as soon as you can so that you can receive your benefits when you need them.

8. Research your Medicare options

Health insurance has never been more vital, so putting a plan in place as soon as possible is recommended. There’s a lot to think about with Medicare, from how your income affects your premiums to when the open enrollment periods are. If you’re turning 65 or going to be receiving Medicare, we encourage you to research your options.

We spoke to Medicare Specialist, Lorraine Bowen, on our podcast, and she answered all of our Medicare questions, including what it covers and how to find out if you’re entitled to it. To learn more about Medicare, listen to this episode.

9. Understand your income plan

When you stop working, you might find it more challenging to keep track of your income. There can be many moving parts in retirement with different income streams and RMDs, and it could leave you with an unnecessarily high tax bill or with fewer cash reserves than you’d like.

Now is the perfect time to adjust your income to ensure that you’re not taking too much or too little. We use a couple of different software programs that help us automatically track income on a month-by-month basis to find a monthly income figure that’s best suited to you. If you want to learn more about how we do this, reach out to us.

Those are our nine key points for preparing your finances for retirement in 2021. By completing this checklist, you’ll be giving yourself peace of mind that you’re on track to achieving your financial goals throughout the year.

We’re going to delve deeper into more of these topics as the year progresses, but if you have any urgent questions about any of the subjects we discussed in this post, please get in touch. You can contact us, or if you want to discuss your retirement goals with a member of our team, we invite you to schedule a 15-minute complimentary call with us.

Roth Conversion – When and How to Plan

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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!