What is a Roth?
A Roth account is an extremely powerful tax tool, which can substantially reduce your lifetime tax burden. Your typical qualified retirement plans are pre-tax, such as when you contribute to your employer’s 401(k) plan or contribute to a traditional IRA (assuming you are under certain income limits). In those cases, your income is reduced by your retirement contribution. This means if you contribute $5,000 to your qualified retirement plan, you’ve then reduced your taxable income by $5,000. For example, if you are in the 22% bracket, that’s a total federal tax savings of $1,100. However, when you retire, you will be taxed on your total distribution. So, in this example, we’ll say you’re still in the 22% tax bracket and the $5,000 contribution has grown to $10,000 in retirement. When you take the $10,000 distribution, you’ll pay $2,200 in federal taxes. A Roth is the reverse. Let’s assume the contribution, tax rate, and distribution amounts are the same as above. In a Roth, your taxable income is not reduced by your retirement contribution. Therefore, you miss out on the $1,100 of tax savings now. However, the earnings in your Roth retirement account will grow tax free and you will not be taxed on the Roth retirement distributions you take out during your retirement. That means when you retire and you take the $10,000 distribution, you pay $0 in taxes.
What’s the difference between a Roth and a Roth Conversion?
A Roth conversion is when you move funds from your pre-tax retirement plan and transfer them to a Roth retirement plan. Because you took a deduction when you initially contributed to your pre-tax retirement plan, when you do a Roth conversion, you must pay taxes on the total amount that you contribute to a Roth. For example, if you convert $10,000 of your pre-tax retirement plan to a Roth, you’ve increased your taxable income in that year by $10,000. Then, just like a regular Roth plan, the amounts you converted will grow tax-free and be tax-free when you take your distributions in retirement.
Why do a Roth Conversion?
Tax free retirement distributions sound good but increasing taxable income now – not so much. However, in the long run the benefit of the tax-free retirement distributions could greatly outweigh the cost of current taxes. It all depends on your unique set of circumstances. See below for times when Roth conversions are a great idea, a possibility, or should be avoided. Do any of these sound like your situation?
Roth contributions and conversions are a no-brainer when:
- You are a student or just starting your career at lower tax brackets.
- You are in early retirement, but not yet drawing on your social security benefits.
- You are in a low tax bracket now and expect to be in a significantly higher tax bracket during retirement.
- You are experiencing lower than usual income this year.
Roth contributions and conversions may benefit you if:
- You and your spouse have a large age gap. After you pass, your spouse will be subject to single person tax brackets which could put them at significantly higher tax rates. Doing a Roth conversion would allow you to leave tax-free retirement distributions to your spouse versus them being subject to a large tax bill after you pass.
- You currently live in a lower income bracket state and plan on moving to a state with higher income tax brackets in the future.
- You plan on leaving your retirement accounts to your heirs and expect them to be in a higher tax bracket than you.
- You will owe estate taxes, and paying the income tax burden during your lifetime will reduce your taxable estate.
Roth contributions and conversions should be avoided when:
- You have college-age children and you are concerned about receiving financial aid or your income is close to exceeding the limit allowable for the American Opportunity Tax Credit. Roth conversions will be considered income for federal aid.
- You are in your peak earning years and expect to be in a lower tax bracket during retirement.
- Other income limitations would be affected at a substantial cost to you, such as IRMAA Medicare surcharges, health care benefits, or being taxed in a much higher bracket.
- You plan on leaving most of your retirement assets to charity, since the charity would not have to pay income taxes in either case.
What makes now a good time?
As mentioned above, if you anticipate having a higher tax bracket in retirement, now would be a good time to put your money in a Roth. I’m not an economist, but based on our government’s current debt and the additional costs involved with COVID relief programs, there is a high likelihood, more than ever, that taxes will be higher in the future than they are now. So, if a Roth conversion is something you’ve been putting off, now is the time to speak to your tax professional or financial advisor. Make sure your financial advisor is qualified to provide tax advice and is willing to put their advice in writing.
Did your business take a big hit in 2020? If so, you likely are going to be in a lower income tax bracket as well, allowing you to make a Roth conversion with minimal tax impact.
The CARES Act removed the requirement to make minimum distributions (RMDs) in 2020, making 2020 a unique year where you can do a Roth conversion for the same amount as your required minimum distribution. This allows you to benefit from the Roth conversion without seeing an increase in taxes due. This works for individuals who do not need to use their RMD for current year expenses.
Our current economic state also has many people unsure about their future and the need for retirement funds. If you have the available funds now to pay the taxes due on conversion, the Roth gives you the flexibility to take distributions – up to the amount you contributed into the Roth – without having to pay any income tax or penalties. For example, if you convert $50,000 to a Roth now and determine later that you need to pull out say $30,000 due to an emergency, you can do so without additional taxes or penalties. This differs from other qualified retirement plans where early distributions result in taxes and penalties of 10% of the amount distributed. We rarely recommend this, since the ultimate goal is to leave your retirement savings untouched. Nevertheless, Roth accounts provide flexibility when needed.
A Roth conversion can be a great retirement and planning tool; however, it is not one size fits all. If you have questions or think a Roth conversion may be for you, please don’t hesitate to contact our office. Our team of financial professionals can coordinate your tax, financial, and investment planning.