Maximize Tax-Free Retirement Savings with a Roth Conversion

Learn how a Roth conversion can boost tax-free retirement savings by converting traditional IRA funds into a Roth IRA with tax-free growth.

What is a Roth Conversion?

A Roth conversion is a transfer of retirement funds from an account with tax-deferred growth (traditional IRA) to an account with tax-free growth (Roth IRA). The taxpayer has to pay income tax on the money that is transferred now, but can make tax-free withdrawals from the Roth account in the future.

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A tax-deferred retirement account is an account where the taxpayer can invest money now without paying taxes on the income until the money is distributed to the taxpayer.

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In what situations can you utilize a Roth Conversion?

#1 You have funds in a Traditional IRA, SEP IRA, SIMPLE IRA, 401(k) or 403(b) account.

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#2 You believe the benefits of transferring current assets to a Roth IRA outweigh the tax liability associated with the Roth conversion. Benefits of holding assets in a Roth IRA include:

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Tax-free income during retirement
Tax-free and penalty-free withdrawals before retirement (subject to limitations, addressed later)
More tax efficient for beneficiaries to inherit
Roth IRAs are currently not subject to required minimum distributions (RMDs) after the age of 72. Taxable RMDs can create unwanted consequences like higher taxable social security income and Medicare premiums. Note: proposed legislation would impose tax-free RMDs from Roth IRA’s valued over $10M.
You have the financial ability to pay tax on the amount you would like to convert

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When can a Roth Conversion benefit you?

If your income is too high to make a Roth IRA contribution, you can enjoy the tax-free growth benefits of a Roth IRA through a Roth conversion
- When is your income too high to make a Roth IRA contribution?
  - In 2022, single taxpayers with modified adjusted gross income (MAGI) of over $144k and for married filing joint taxpayers $214k
There is no limit to converting existing (already contributed) funds to a Roth IRA. Contributions of new funds to a Roth IRA are limited to $6,000 per year ($7,000 if you’re over 50).
If your current tax-deferred retirement plan holds assets that have decreased in value but you expect a substantial increase over time, you can pay tax on the lower value and enjoy tax-free growth
Eliminate the risk of being subject to a higher tax rate during retirement by paying tax at your current rate
You can decide how much extra income you want to recognize now by doing a partial conversion. A partial conversion is a great option if you only want to pick up a certain amount of income so that you don’t get pushed to a higher tax-bracket.
Converted funds can be withdrawn tax free after a 5 year holding period is met.

Keep an eye 👀 (or two) out for the following (Cons)

Once you convert a tax-deferred account into a Roth account, you can not move your money back to a tax-deferred account.
When you utilize the Roth Conversion, you will pay tax at your current rate on any amounts converted. You need to have enough savings to pay the tax immediately.
Any funds withdrawn before the five-year holding period is met will be subject to income tax plus a 10% early distribution penalty, even if you are over the age requirement (59.5) for penalty-free distributions. (exceptions apply)
Recognizing more income now might push you to the next income tax bracket, as well as subject you to net investment income tax.
If you plan to leave most of the value of your retirement accounts for your beneficiaries, and they are in a lower tax bracket, you should keep in mind that the conversion might not be as effective.
If proposed legislation passes, Roth IRA conversions could be prohibited for high-income individuals and RMDs would be imposed on Roth accounts that have greater than 10 million dollars in value.

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A Roth Conversion In Action

You are a single individual and your taxable income before a Roth conversion is $180,000 (subject to a tax rate of 32% per the IRS 2022 tax rate schedule). Your traditional IRA account holds $100,000 worth of assets in January 2021. In May, 2022, the assets have decreased in value to $65,000. You expect that the value will go back up so you convert the $65,000 worth of assets from your traditional IRA account into a Roth IRA account. Since you are converting the money, you must pay tax on the $65,000 now at an approximate tax rate of 35%, or $22,750, since the $65,000 pushed you to the next income tax bracket from 32% to 35%.
Twenty years later, you are 60 years old and want to take out distributions from your Roth IRA account. The value in the account is now $1 million dollars and you want to take it all out. The distributions are not included in taxable income and are tax-free so you do not pay any tax at this time.
In this example, the $925,000 ($1 million value at age 60 less the $65,000 value at Roth conversion) of growth will be tax-free, so you saved $301,000
- $301,000 = $323,750 (which is 35% of $925,000 growth) - $22,750 (taxes paid on Roth conversion)
If you had not done the Roth Conversion, you would have foregone the $22,750 taxes paid now, but the distribution would be included in taxable income and you would have to pay taxes on the $1 million dollars when distributed at age 60. (which would be around $323,750, using the 2022 highest tax brackets.)

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Key Terms

Withdrawal = when you take money out of your retirement account before 59 1/2 (also known as an early distribution)
Distributions = when you take money out of your Roth IRA after 59 1/2 (considered retirement income)
RMD = Required minimum distributions

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This information is for educational purposes only and does not constitute financial advice. Consult a qualified professional before making any investment decisions.

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