What is a Roth Conversion?
A Roth conversion refers to taking all or part of your Traditional IRA and moving it into a Roth IRA. One major point of a Roth conversion is taxes. Converting your traditional IRA into a Roth IRA will cause you to pay taxes on that money immediately. However, if you think tax rates may go up in the future, or that your taxable income will be greater, a Roth Conversion that has tax free withdrawals later down the road may be right for you. The hard truth is taxes control a lot of our finances. They can limit us if we’re not proactive on finding ways to minimize them.
Here are Four Key Benefits of a Roth IRA Conversion:
1) Tax Free withdrawals in retirement
The tax benefits of a Roth IRA are clear: Tax-free growth potential and tax-free withdrawals in retirement. If you aren’t able to contribute to a Roth IRA because of limited income, a Roth conversion of eligible retirement accounts is another way to have a Roth account. A Roth IRA, even via a conversion, has the potential to benefit your retirement and legacy planning.
2) No RMD’s
One of the major advantages of a Roth IRA, unlike traditional IRAs and many types of retirement plans, is that you don’t have to take any required minimum distributions RMD’s (A required minimum distribution, or, the amount of money that must be withdrawn from an employer-sponsored retirement plan, traditional IRA, SEP, or SIMPLE individual retirement account) during your lifetime. So, if you don’t need the money for living expenses, your account will continue to grow tax-free. This makes a Roth IRA a great option for wealth transfer.
Which leads to #3…
3) Tax free inheritance to heirs
What happens to your Roth IRA depends on who your beneficiary is. For example, transferring the Roth IRA to a spouse as if it were their own. Other kinds of beneficiaries wouldn’t be able to do so, rather they would have to withdraw all the funds from a Roth account within a 5-year period after you pass. As long as you were the account holder for five years, the distributions on the Roth will be completely tax-free.
4) No income limits to convert
The advantage to converting from a traditional IRA to Roth IRA is that while you can’t contribute to a Roth IRA if your income exceeds the limits set by the IRS, you can convert the traditional into a Roth to make it a “backdoor Roth IRA.” Meaning, you can convert a limitless amount of money into a Roth IRA. You’ll still owe taxes on the money you convert, but you’ll be able to take tax-free withdrawals from the Roth IRA in the future.
Deciding whether to convert to a Roth IRA brings up concerns like your tax rate now versus later, the tax bill you’ll have to pay to convert, and your future plans for your estate. And remember, the conversion will be permanent—you can’t revert the money back to a traditional IRA.
Roth Conversions are a very personalized strategy. Some advisors think they are appropriate for everyone but we say it’s best to review your situation with financial and tax advisors. The amount that you convert is taxable in the year of conversion, so you need to plan accordingly.
Unfortunately, as part of the Tax Cuts and Jobs Act back in December 2017, Congress eliminated the ability to undo Roth conversions (then called a recharacterization), so there isn’t a way to undo a conversion. Roth conversions are final now, and the tax will be owed.
The bottom line is, a Roth IRA is a very attractive retirement savings vehicle but you have to pay attention to the details when converting so you don’t get jammed up!
Additional Resources
