Recently, many of my clients have come to me with questions about converting to a Roth IRA. Moving money from a traditional IRA to a Roth IRA (often referred to as the “pay taxes now or later” debate) presents some complications. It’s also irreversible, so it’s understandable that many investors struggle to make the best choice. Here are answers to some frequently asked questions, including a story of how making the right choice saved a customer $26,000.
What is the difference between a traditional IRA and a Roth IRA? The biggest difference between a Roth IRA and a traditional IRA is when you pay your taxes. Contributions to a traditional IRA are tax deductible, but retirement withdrawals are taxable. Roth IRAs work in the opposite direction. Contributions to a Roth IRA are not tax deductible, but qualified retirement withdrawals are tax deductible. Essentially, it’s about paying taxes now (Roth) or later (traditional). Who should consider switching?
I always start by looking at the client’s financial situation and goals. Here are some situations where switching from Legacy to Roth can be beneficial:
You have retired or have recently reduced your income (meaning you are now in a lower tax bracket).
Your future income could be higher, putting you in a higher tax bracket.
You worry about future tax increases. You see tax efficiency as a key objective.
You want to bequeath a tax-free estate to your heirs.
What are the tax advantages of a Roth conversion?
We often talk about how to diversify the assets in your portfolio, but it also helps diversify your tax strategy. For some, the Roth conversion can provide:
Avoid uncertainty. No one can predict what tax rates will be or how they will change over time. Current tax rates and estate tax exemptions expire in 2025 and may change as part of the Build Back Better plan. You can hedge your tax exposure by saving money in a wider range of taxable and tax-advantaged accounts. This way, you reduce the risk of the value of your investment falling due to changes in tax laws.
Tax-free retirement withdrawals. Unlike withdrawals from a traditional IRA, withdrawals from a qualified Roth IRA are generally tax-free. If you are under age 59.5 at the time of withdrawal, you may be subject to taxes and penalties, with some exceptions.
Tax-free growth. A Roth IRA has no minimum distribution requirement (RMD) over your lifetime, so your money can stay in your account and continue to grow tax-free.
Tax-free inheritance. When your beneficiaries inherit IRA assets, they must, in most cases, distribute them within 10 years of your death. With traditional IRA assets, these distributions would be considered taxable income, while Roth IRA assets are tax exempt.
If you’re ready to get started, we provide tutorials to make the process easier.
Do I have to withhold tax if I change?
The amount you convert to a Roth IRA is taxable, but you are not required to withhold taxes upon conversion. You can choose to pay it when you file your tax return, but you may be penalized with late fees if the bill is large enough. Review your overall tax situation with a tax advisor and make a tax estimate if necessary, preferably from non-IRA assets.
By paying taxes from sources other than retirement, you maximize the benefits of change by allowing more dollars to grow in the Roth instead of being used to pay taxes.
When is conversion inappropriate?
One of the main disadvantages of conversion is the tax bill. If you’re still earning a decent income, your tax rate is likely to be higher now than it was in retirement. In this case, you’re better off putting the money in a traditional IRA, because the switch could be tax-heavy.
Consider when you will need the money, as there is a 5 year holding period in Roth conversions. Your capital gains tax rate will also be affected. Capital gains tax rates are income-related, so the amount you convert may push you into a higher tax bracket. What else can affect conversion?
Health care is a big piece of the Roth conversion puzzle. Your Medicare Part B premiums may increase if the change brings your taxable income above a certain threshold. Too big of a change can also result in a higher percentage of Social Security benefits being taxed. If you are under age 65 and not yet eligible for Medicare, and your employer’s plan no longer covers you, you may be looking for an Affordable Care Act (ACA) market plan to meet your needs. health insurance needs. The ACA program offers additional tax credits to families earning between 100% and 400% of the federal poverty level. However, there is a “subsidy cliff” at 400% of the poverty line, which means that if you earn an extra dollar, you have to pay a full premium. These grants can amount to thousands of dollars per year, so disqualifying you from a Roth conversion can be a significant expense.
However, there is good news. The American Rescue Plan Act (ARPA) of March 2021 increased grants and eligible income for 2021 and 2022. This gives people enrolled in the Marketplace plan the ability to switch to a Roth IRA without losing their health insurance benefits due to a temporary increase in income.
This is where the client side I mentioned earlier comes in. He retired in 2019 and intends to transition Roth during his retirement. It seemed like a good idea for a number of reasons, but when I discussed the impact of the ACA tax credit, the equation changed. If he converted the way he wanted, he would lose the tax credit and have to pay about $26,000 more in health insurance premiums. These costs far outweigh the benefits of his change strategy, so he decides not to change. Imagine what that would mean for his retirement.
Want to save even more?
What is a “backdoor” Roth transformation?
Roth IRA contributions have income limits, but even if your income is too high, there is a process to convert to a Roth IRA. First, you make non-deductible contributions to a traditional IRA with no income limit. Then you use a Roth conversion to transfer money into a Roth IRA. 2021 may be the last year this will be allowed, as conversions to after-tax dollars are being reviewed in Washington and may not be allowed in future years.
Some of them work for me, but how do I know if the Roth transformation is right for me?
Roth conversions are permanent, so if you’re still unsure, consult an advisor. We can help you make choices that match your goals.
I became a consultant because I wanted to help people overcome their financial difficulties. Every time I get someone to make a decision in their favor, I know I’ve accomplished something worthwhile. Whether it’s $26 or $26,000, I’m with you.