Matter & Substance
  July 27, 2023

Maximizing Savings with Roth Conversions

Saving for retirement is a critical financial goal for every individual. Traditional Individual Retirement Accounts (IRAs) have long been popular choices, but Roth IRAs and conversions offer unique advantages that can significantly benefit taxpayers and their heirs. 

The major advantage of converting a traditional IRA or 401(k) into a Roth IRA is the ability to make tax-free withdrawals in the future. That can be particularly appealing if you expect to be in a higher marginal tax bracket in retirement.

Understanding Roth Conversations

Roth conversions are a strategic financial maneuver that involves transferring funds from a traditional IRA or other pre-tax retirement account to a Roth IRA. Unlike traditional IRAs, which offer tax deductions on contributions but tax withdrawals in retirement, Roth IRAs work in reverse. Contributions to Roth IRAs are made with after-tax dollars, but the earnings grow tax-free. Withdrawals are tax-free if you’re age 59½ or older and the account has been open for at least five years.

Roth IRAs are subject to income limits for eligibility, with income limits adjusting from year to year. If you earn too much, then your eligibility is limited or eliminated. (For 2023, the contribution limit is $6,500 or $7,500 if you're over 50. The Roth IRA income limits for 2023 are less than $153,000 for single tax filers, and less than $228,000 for those married filing jointly.)

The Roth conversion process requires taxpayers to pay taxes on the amount transferred from a traditional IRA, which may result in an immediate tax liability. However, the potential benefits lie in the long-term tax savings and flexibility offered by Roth IRAs, making them an attractive option for those seeking to optimize their retirement savings and reduce tax burdens in their golden years.

How a Roth IRA Conversion Works

A conversion may be accomplished in several ways:

Direct rollover: Transaction from a defined-contribution plan, such as a 401(k) or 403(b), which is done typically if you're leaving your job and have an account with a former employer. The plan's administrator can send the money to your new account or give you a check made out to the new account that you can then deposit.

Trustee-to-trustee transfer: Assets are directly transferred from the financial institution, or trustee, where your traditional IRA is held to the one where your new Roth IRA will be held.

60-day rollover: Retirement funds are paid to you, and you then deposit all or part of them in a Roth IRA within 60 days. With a 60-day rollover, if you fail to deposit the money within that time, it will be treated as taxable income. You may also face a 10% tax on early distributions if you're under age 59½.

The Power of Roth Conversions

Roth conversions involve transferring funds from a traditional IRA or other pre-tax retirement account into a Roth IRA. During the conversion process, the taxpayer must pay taxes on the amount converted. While this incurs an immediate tax liability, the long-term benefits can be substantial. Conversions enable taxpayers to take advantage of the tax-free growth and withdrawals offered by Roth IRAs, even if they exceed income limits for direct Roth contributions.

Additionally, Roth IRAs can be powerful estate planning tools. By converting traditional IRAs to Roth IRAs, taxpayers can leave their heirs a tax-free inheritance. Beneficiaries of Roth IRAs inherit the accounts tax-free and can continue to enjoy tax-free growth if they follow the distribution rules. Heirs will have the option to stretch the inherited Roth IRA by taking required minimum distributions over their life expectancy. This approach can maximize the account's tax-free growth potential while minimizing the tax impact on beneficiaries.

Factors to Consider for Roth Conversions

Current vs. Future Tax Brackets: Before converting, taxpayers should evaluate whether they are in a higher or lower tax bracket now compared to their projected tax bracket in retirement. If they expect to be in a lower bracket during retirement, a conversion might not be as beneficial.

Ability to Pay Conversion Taxes: Converting a traditional IRA into a Roth IRA incurs an immediate tax liability. Taxpayers must ensure they have sufficient funds outside of the retirement account to cover these taxes, as using retirement funds may diminish the long-term benefits.

Timing of Conversions: Converting during years with lower income or deductions can be advantageous, as it may lower the tax rate applied to the conversion, such as in years with business losses or net operating losses, or years with large medical or charitable deductions. In years where you have a lower taxable income, you can make better use of the lower marginal tax brackets. Additionally, spreading conversions over multiple years can help manage tax implications and prevent pushing into a higher tax bracket.

We're here to help

Roth conversions present an opportunity for taxpayers to save money and leave a tax-efficient inheritance to their heirs. Understanding the factors to consider, including timing and estate consequences, is essential in making the most of these retirement accounts. By carefully evaluating your financial situation and long-term goals with your tax partner, you can harness the potential benefits of Roth conversions.