What Are Roth IRA Conversions?

May 2021Roth IRA golden egg

As you plan for retirement, it’s important to invest your money in a way that maximizes your income in your senior years. In some cases, a Roth IRA conversion could get you closer to this goal by allowing you to pay less in taxes when you retire. Before you take this route, it’s important to understand the basics of Roth IRA conversions and determine whether they fit your specific financial situation.

What is a Roth IRA?
There’s a big difference between Roth IRAs and options like a traditional IRA or 401(k) plan. Traditional plans let you contribute money that’s only taxed when you withdraw it in retirement. But when you contribute to a Roth IRA, the money you put in has already been taxed. Your contributions and earnings will grow tax-free, and you won’t owe the IRS anything when you withdraw money.

What is a Roth IRA conversion?
A Roth IRA conversion is simply a transfer of money from your traditional retirement account to a Roth IRA. When you do this, you’ll need to pay the deferred taxes on the amount you withdraw before it goes into the Roth IRA. According to Jean Folger’s article for Investopedia, once the money has been transferred, you can withdraw it penalty-free from the Roth IRA after you’ve met two conditions. First, you must wait five years. Second, you must be at least 59½ years old.

Benefits of a Roth IRA conversion
Roth IRA conversions come with a variety of potential benefits. Mark Stein writes for Kiplinger that taxes are the lowest they’ve been in decades. Making a conversion and taking the tax hit now could save you money farther down the road if tax rates go up again. Converting to a Roth IRA could also benefit you if you expect your income to keep growing. Even if you end up in a higher tax bracket later in life, your Roth IRA withdrawals would help lower your taxable income.

Per Folger, a Roth IRA conversion offers a major upside for higher earners. Normally you can’t contribute to a Roth IRA if your modified adjusted gross income exceeds $140,000 (or $208,000 for joint filers). However, there’s no such restriction on conversions, giving you “backdoor” access to a Roth IRA’s eventual tax advantages even if you wouldn’t otherwise be eligible.

Roth IRA conversions also come with another perk for the well-to-do. Unlike traditional retirement accounts, you don’t have to make withdrawals, known as required minimum distributions, from your account once you turn 72 years old. If you don’t need the money, this means you can leave it untouched and pass it on to your heirs tax-free.

Drawbacks of a Roth IRA conversion
Roth IRA conversions aren’t right for everyone. The biggest drawback is the fact that you’ll owe the applicable state and federal taxes on the transferred amount. This could be a significant sum of money, especially if you’ve built up savings over the years. Stein warns that it could even push you into a higher tax bracket for the year. If paying these taxes will stretch your finances too severely, you may be better off sticking with your current arrangement.

Timing and uncertainty are two more drawbacks. Long-term tax savings are the primary reason to go through with a Roth IRA conversion, but if you’re near retirement, there may not be enough time for it to pay off. A conversion also might not pay off if you expect to be in a lower tax bracket once you retire, or if your financial position is uncertain.

Roth IRA conversions are a powerful investment tool, but they’re not for everyone. As you assess your financial future, be sure to consult with our bankers to determine the right retirement savings strategy for your needs.