Why, Why Not, and How to Do a Roth Conversion: A Strategic Guide
When planning for retirement, one of the key decisions you'll face is how to manage your tax liabilities. A Roth IRA conversion can be a powerful strategy, but it's not without its complexities.
Why Consider a Roth Conversion?
Tax-Free Withdrawals in Retirement
One of the most compelling reasons to convert to a Roth IRA is the benefit of tax-free withdrawals. Once you reach age 59½ and have held the Roth IRA for at least five years, your withdrawals—including earnings—are entirely tax-free. This can provide significant tax savings in retirement, especially if you expect to be in a higher tax bracket than you are today.
No Required Minimum Distributions (RMDs)
Traditional IRAs require you to start taking RMDs at age 73, regardless of whether you need the money. These distributions can increase your taxable income and potentially push you into a higher tax bracket. Roth IRAs, on the other hand, do not have RMDs during the original owner’s lifetime, allowing your investments to grow tax-free for as long as you wish.
Estate Planning Benefits
Roth IRAs can be a useful tool for estate planning. If you don't need the funds during your lifetime, you can leave your Roth IRA to your heirs, who will inherit the account income tax-free. While they will need to take distributions, the funds will continue to grow tax-free during their lifetimes.
Tax Diversification
Having both a Roth IRA and a Traditional IRA gives you flexibility in managing your tax bill in retirement. You can strategically withdraw from either account depending on your tax situation each year, potentially reducing your overall tax burden.
Why a Roth Conversion Might Not Be Right for You
Immediate Tax Liability
The biggest downside to a Roth conversion is the immediate tax hit. When you convert, the amount you move from your Traditional IRA to a Roth IRA is added to your taxable income for the year. This could push you into a higher tax bracket, resulting in a substantial tax bill.
Timing Matters
Converting to a Roth IRA is generally more advantageous when you're in a lower tax bracket. If you expect your income to decrease in the future (for example, if you're planning to retire soon), it might make sense to delay the conversion until then. Conversely, if your income is expected to rise, converting sooner could be beneficial.
The Break-Even Point
It’s important to consider how long it will take to "break even" on the taxes paid during the conversion. If you’re close to retirement and won’t have many years for the Roth IRA to grow tax-free, the immediate tax hit may not be worth it.
You and Your Financial Professional Have Decided a Conversion is Right for You: What Is The Next Step?
Understand the Tax Impact
Before initiating the conversion, calculate the tax impact. The amount converted will be added to your taxable income for the year, so it’s essential to understand how this will affect your tax bracket. Consider converting a portion of your Traditional IRA each year rather than all at once to manage your tax liability.
Decide on the Amount to Convert
You don’t have to convert your entire Traditional IRA in one go. Many people choose to convert smaller amounts over several years to minimize the tax impact. This strategy can help you avoid jumping into a higher tax bracket.
Initiate the Conversion
Contact your IRA custodian to initiate the conversion. You can opt for a direct transfer, where the funds are moved directly from your Traditional IRA to your Roth IRA, or a 60-day rollover, where you withdraw the funds and redeposit them within 60 days.
Pay the Taxes
Plan to pay the taxes from a source outside your IRA to keep more money growing tax-free in your Roth IRA.
Report the Conversion on Your Tax Return
You’ll need to report the conversion on your tax return using IRS Form 8606. Your IRA custodian will also send you Form 1099-R, which details the amount converted.
Final Thoughts
A Roth conversion can be a smart financial move, especially if you’re looking to maximize your tax-free income in retirement or want more control over your RMDs. However, it’s not the right choice for everyone. The decision to convert should be based on your current financial situation, tax considerations, and retirement goals.
At Whitener Capital Management, we can help you determine if a Roth conversion makes sense for you and guide you through the process. Contact us today to discuss your retirement planning strategy.
