Pay The Tax: Converting From A Traditional To A Roth IRA

Dana Maury |

What is a Roth IRA?

  • A Roth IRA is a retirement account funded with post-tax earnings that allows all future earnings, gains, and withdrawals to be tax-free, assuming certain conditions are met.

What Are the Benefits of a Roth IRA?

  • Assuming you are 59 ½ and your funds have been in the Roth account for 5 years, all gains and income in the account is tax-free upon distribution.
  • Roth IRAs do not require you to take a required minimum distribution (RMD) at any point in your lifetime, whereas a traditional IRA requires a mandatory withdrawal annually following the account holder’s 72nd birthday. With a Roth IRA, if you don’t need your money, you can leave it in the account and let it continue to grow.
  • Your heirs will inherit any unused funds tax free. Your heirs will have to take an RMD, but they won’t have to pay tax on any gains or earnings in the account.
  • You can convert an existing IRA to a Roth IRA, even if you earn above the annual Roth IRA income limit ($204,000 if married filing jointly in 2022). This is a good workaround for those that can’t get exposure to a Roth IRA because of income limitations and can provide some post-tax asset diversification.

When is the Best Time to Convert to a Roth IRA?

  • You have funds available outside of the IRA to pay the income taxes due with the conversion: If you are under age 59 ½, then withdrawing funds from your IRA would trigger a 10% penalty, in addition to the income tax you’re already paying. Plus, you want to leave as many assets in the Roth to continue growing free of future tax liabilities.
  • You are in a lower tax bracket now than you will be at retirement: If you’re currently in a lower tax bracket, and you expect your future earnings to increase, paying a lower tax rate now could be more tax efficient and alleviate a future tax burden.
  • When You Don’t Need the Money for 5 Years: Roth IRAs require contributions to be maintained for 5 years in the account before withdrawing them. If you’re 58 and plan to start removing funds at age 60, now is not the best time to convert to a Roth.
  • If you do not want to incur the tax liability of converting an IRA in one tax year, you are allowed to do a partial conversion to a Roth IRA. As an example, you could smooth out the tax hit and convert your IRA over a 5-year period.
  • When Asset Values are in a Depressed Period: The stock market has had a volatile year in 2022. As an example, the S&P 500 Index was down over 25% year-to-date on October 3. However, the drop in the market does create an opportunity when considering a Roth conversion. An individual pays ordinary income tax on funds removed from a Traditional IRA or 401(k), so decreased stock prices will allow the investor to convert to a Roth IRA, while paying lower income taxes. As an example, a Traditional IRA could have had a balance to start 2022 at $100,000, but with the correction in the market that portfolio is now worth $80,000. Paying taxes on the $80,000 will incur a lower tax liability and allow the investor to experience a future, potential market rebound tax-free.

 

The opinions expressed are subject to change from time to time and do not constitute a recommendation to purchase or sell any security nor to engage in any particular investment strategy. This document is for informational purposes only. The views stated in this document should not be construed, directly or indirectly, or as specific investment advice for an individual’s situation. Investors should be aware that there are risks inherent in all investments, such as fluctuations in investment principal. With any investment vehicle, past performance is not a guarantee of future results. The information in this material is not intended as tax or legal advice. Please consult legal or tax professionals for specific information regarding your individual situation.