Contributions to a Traditional IRA are done with pre-tax income. Similar to a 401(k), the amount you contribute to a Traditional IRA is tax deductible up-front, reducing your taxable income. The money then grows overtime tax-deferred, and is subject to taxation only upon withdrawal during retirement. You are effectively delaying taxation with a Traditional IRA, not avoiding it.
Funding a Roth IRA is done with after-tax income. The contribution is not tax deductible. However, the contribution and any investment gains are 100% tax free upon withdrawal. Because you do not receive an upfront tax deduction, a Roth contribution is about the delayed gratification of accruing tax free assets. The prospect of having an investment account that is 100% tax free is attractive to most people, but not possible for everyone.
First, the Roth IRA was not originated until 1997. Investors prior to 1997 had not choice but to contribute to a pre-tax retirement account. For most people, a pretax retirement account is still their only option for saving out of their paycheck through an employer sponsored retirement account. In addition, you cannot contribute to a Roth IRA if your income is over an IRS threshold of about $123,000 for single filers and $193,000 for joint filers. And even if you can contribute, the maximum is $6,000 per year per person. So if tax free sounds attractive, and you find yourself behind on Roth balances, a conversion might be a helpful tool.
What is a Roth Conversion?
A short answer would be when you withdraw/transfer money from your pre-tax account, like a Traditional IRA, SEP IRA, or SIMPLE IRA, and you move it to a Roth IRA. In doing this, you pay taxes on the amount you withdraw from the pre-tax account and move to the Roth IRA in the year of the conversion. This increases your taxable income for the year of the conversion, but allows converted money to grow tax-free.
Example:
Say Jerry earns $100,000 from his job in 2018. He has $50,000 in a pre-tax Traditional IRA and he would like to convert to $10,000 a Roth IRA. When he converts the $10,000, it will be added to his regular taxable income for 2018. Jerry will pay tax on the combined amount of $110,000 at his regular tax rate for that year.
When would you use a Roth conversion, and how can it benefit you?
Roth Conversions can help you manage your retirement cash flow. Pre-tax retirement accounts are subject to Required Minimum Distributions (RMD’s); which require an individual to withdraw from the account account at age 70.5 years old. RMD’s are taxable as ordinary income. A Roth IRA is not subject to RMD’s. By converting pre-tax investments to Roth, you are allowing that money to stay in the account until you need or want to withdraw it. Rather than being forced to take taxable distributions starting at 70.5, you now have the flexibility to withdraw whenever you want, tax free.
Large RMDs in retirement will especially add to your taxable income and possibly send you into a higher tax bracket. The larger the account, the larger the RMD. You cannot invest that amount back into a tax-advantaged account such as a Roth, unless you have earned income. By converting money into your Roth account before you are 70.5, you can avoid taking significant RMD’s, lowering your tax burden during your later retirement years. None of know what tax rates will be in the future, but the tax free status of a Roth ensures you won’t be subjected to abnormally high tax rates at the wrong time.
A secondary benefit for a Roth Conversion would be to pass money to your heir’s tax-free. This could mean leaving accounts to your spouse after you pass or your children. Let us look at an example.
Example:
Let us use Jerry’s case again. Jerry is 70.5 years old and he retired at age 64. From 64-70, he converted some of his pre-tax IRA to Roth. Now at 70.5 years old; he is starting to take RMDs on the amount left in his pre-tax IRA. Jerry does not need to withdraw any amount from his Roth IRA. Jerry passes away at age 75, his wife Linda (age 75 as well) is beneficiary on his accounts. Since Linda is his spouse, she can treat his pre-tax and post-tax accounts as her own. She will continue to take RMD’s based on her life expectancy from the pre-tax IRA, but she will not have to withdraw anything from the Roth.
Linda dies at age 82 and leaves the Roth IRA to her daughter Mary who is 55. Mary has two options with the inherited Traditional IRA and Roth Account. She can deplete the accounts within five years, or she can begin taking RMD’s from the account for the rest of her life. Both Beneficiary IRAs are subject to required distributions; However the Roth is tax free and the Traditional IRA is taxable, at Mary’s tax rate.
By converting his pre-tax IRA to Roth, Jerry allowed the money to grow tax-free for the remainder of his and Linda’s lives, then it passed tax-free to Mary.
If Jerry never converted any money to Roth, his RMD’s would have been higher, which would have increased his tax burden. When he passed, Linda continues to take RMD’s through the end of her life. When Linda passed, the RMDs continue as taxable income to Mary. Mary is in her peak earning years and consequently in a much higher tax bracket than her retired parents were. If she takes RMD’s based on her life expectancy, they will be taxed at a higher rate. Meaning she will benefit far less from the IRA balance after taxes are paid.
What about a Backdoor Roth? How does that work?
If your income is above the IRS threshold, you cannot contribute to a Roth. A Backdoor Roth is a type of Roth conversion done on an annual basis. The Backdoor Roth strategy requires an article all to itself. For now, understand it’s an option that we will elaborate on later.
When is the best time for a Roth conversion?
The short answer is, whenever your taxable income is lower than normal or expected. Probably the most common time would be between your retirement and your Social Security full retirement age (FRA). Take Jerry’s case where he converted his account between ages 64 and 70. If his Social Security FRA is 66, his best opportunity for Roth conversions is between 64 and 66. His second best opportunity is between 66 and 70.5 (before RMDs start). During this period, most people have lower incomes and are in a much lower tax bracket, an ideal time to use conversions. Other times could be more unexpected; you are in between jobs, you’re in a sales role with varying income year to year, or a spouse takes time off work. Anytime your income drops presents an excellent opportunity to convert pre-tax money to Roth.
Roth Conversions take planning and require looking at the long term benefits over the short term tax bill. No one wants to voluntarily pay more in taxes to the IRS. However, Roth conversions could benefit your retirement plan by taking a long term view. Plan ahead and take action when the opportunity presents itself. Roth conversions are a tool you can use for planning and offer several advantages when implemented correctly.
History of Federal Income Tax Rates: 1913 – 2020
Taxes on the Rich Were Not That Much Higher in the 1950s
The Ultimate Roth IRA Conversion Guide – Everything You Need to Know
How to Use a Roth IRA as Part of Your Estate Plan
Amount of Roth IRA Contributions That You Can Make For 2019
Retirement Topics — Required Minimum Distributions (RMDs)