Saturday, September 17, 2022

Roth Conversions: What is it and how to do one?

InvestingRoth Conversions: What is it and how to do one?

Today, I will be covering Roth Conversions. Many people will weigh the differences between a traditional IRA account and a Roth IRA at some point in their working lives. While they each have their benefits and drawbacks, many are drawn to Roth IRAs because of the tax benefits accountholders enjoy during retirement and the ability to avoid required minimum distributions after 72.

The good news is that if someone has been saving up for retirement in a traditional IRA account, they are not stuck with this structure forever. With a Roth conversion, those with a traditional IRA can transfer their funds into a Roth IRA account, though they will be subject to additional taxation. Even still, many find that the pros largely make up for the cons when it comes to a Roth conversion, which is why many continue to utilize this strategy.  

An important aspect to point out is that before December 31, 2017, Roth conversions could be turned back into traditional IRAs; however, that is no longer permitted. Therefore, account holders should make the proper considerations ahead of time, as it cannot be reversed once it’s completed.

Roth Conversion Defined

Let’s start off by defining what a Roth conversion is. As the name might suggest, this occurs when someone transfers their retirement assets from a traditional, simplified employee pension (SEP), SIMPLE IRA, or 401(k) into a Roth IRA. 

The specific tax implications of this transfer and the scenarios when one would want to consider a Roth conversion can be more complex, so we will discuss each of these aspects at greater length below. 

How a Roth Conversion Works

Now with a better understanding of what a Roth conversion is, we can discuss how exactly it works. There are a few different ways that a Roth conversion can be completed: a direct rollover, a trustee-to-trustee transfer, and a 60-day rollover. Let’s take a deeper look at each of these. 

Direct Rollover

Direct rollovers can be made from a defined-contribution plan like a 401(k) or 403(b). Mainly this occurs when a worker leaves their job or had a previous account with a former employer that they had left open.

Under this method, the previous plan’s administrator will send the money to your new account or will provide you with a check written out to the new account which you will then deposit for yourself.

Trustee-to-Trustee Transfer

Another method is to use a trustee-to-trustee transfer. In this case, the assets from the traditional fund will be directly transferred to the institution where your Roth account is. 

In some cases, it may end up being a different account within the same institution, in which case you may see it referred to as a same-trustee transfer. Many will utilize this option or the direct rollover because the transfer can be completed by the institutions and not rely on the accountholder to make the proper deposits at the right time. 

60-Day Rollover

The last method for a Roth conversion that we’ll discuss here is the 60-day rollover. When done in this manner, the funds from the traditional account are provided to you, then you can deposit all or a portion of it to a new Roth IRA account within 60 days.

This may sound appealing; however, it is seen as the riskier of the three options for Roth conversions. This is because if you don’t deposit the funds within the timeframe of 60 days, you could be subject to paying income tax on that amount, and could face an additional 10% penalty tax on early distributions if you are not yet 59 ½ years old. Additionally, unlike the other two methods, a 60-day rollover may be subject to a 10% tax withholding. 

What to Consider Before Making a Roth Conversion

A Roth conversion doesn’t always make sense for account holders of a traditional IRA or 401(k).  So, let’s take a look at some of the considerations that one needs to make before they make a Roth conversion that cannot be undone. 

Higher Future Tax Bracket

Given the taxation structure of traditional accounts compared to Roth IRAs, one might consider a Roth conversion if they expect to be in a higher tax bracket in the future. This means that their tax liabilities now when making the contributions would be less than what they would pay on withdrawals in the future. Thus, they’d prefer to pay the taxes now, and take tax-free distributions in the future.

Even though the trend is that people’s income tends to be lower in retirement, this isn’t necessarily true in all scenarios. Depending on the various retirement accounts and other income streams that someone has set up throughout their working years, once required minimum distributions kick in at age 72, a retiree’s income could increase by quite a bit. 

Changes in Marginal Tax Rates & Brackets

This may not be at the top of everyone’s mind, but there is no guarantee of what the tax brackets and marginal tax rates will be in the future. So some would prefer to pay the taxes now when the tax liabilities are somewhat predictable, rather than relying on the unknown of the future tax rates once in retirement. 

Estate Planning

In addition, some traditional account holders will need to consider their estate planning and how the type of account they have could impact what they’re able to leave behind to beneficiaries.

One characteristic of Roth IRAs makes them particularly appealing to those who are hoping to leave their wealth to loved ones once they’ve passed. Unlike other retirement accounts, Roth IRAs are not subject to required minimum distributions.

This is important because if you do not need the funds or distributions from the Roth IRA to live off of during retirement, there are no penalties to pay if you would rather leave it alone and allow it to grow in value, which can then be left to beneficiaries later on.

If a spouse is the beneficiary of the Roth IRA, they will also not be subject to the required minimum distributions. However, children or other beneficiaries would have to take distributions at some point, but they would still be tax-free.  

Tax Implications of a Roth Conversion

When making a Roth conversion, account holders will likely face some additional taxes. First, they must pay taxes on the funds that are converted given their tax bracket at the time, and the amount that’s converted. However, the withdrawals from the Roth account will be tax-free once they’re taken in retirement. 

While taxes on the conversion cannot be avoided altogether, there are certain strategies that can be utilized in order to keep the tax liabilities as low as possible. One of these methods is to convert an amount that won’t put the individual into the next tax bracket. Because of this, some people will spread out the Roth conversion over a number of years in order to avoid jumping up into a higher tax bracket.

On a similar note, traditional account holders may wait until a year when they have a lower income than usual, like if they’re between jobs or taking time off for whatever reason. Just like as above, this is done in order to avoid entering the next marginal tax bracket. 

Final Thoughts on Roth Conversions

Taking all these points into consideration, it’s clear to see that a Roth conversion could be beneficial in certain scenarios. The tax-free income in retirement is a major draw for many, which is why a Roth conversion is often considered. So for those who expect to be in a higher tax bracket once in retirement and want the flexibility not to have to take distributions, a Roth IRA could be a better retirement account for these individuals.

The good news is that there are financial professionals out there who are qualified to help you navigate these decisions, and can help you become financially prepared for this next big stage in your life. To hear more about these topics and others relating to college planning, join one of our upcoming webinars to start taking control of your financial health. 

Photo by Barry Weatherall

Tom Martin, WMCP®
Tom Martin, WMCP®
Tom Martin, is a financial advisor at Vaylark Financial Services, based in Hartford, Connecticut. He practices in the area of private wealth management offering comprehensive financial planning, custom investment portfolios, tax reduction strategies, risk management, estate and legacy planning, as well as advises on executive compensation and business owner profitability.

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Tom Martin, is a financial advisor at Vaylark Financial Services, based in Hartford, Connecticut. He practices in the area of private wealth management offering comprehensive financial planning, custom investment portfolios, tax reduction strategies, risk management, estate and legacy planning, as well as advises on executive compensation and business owner profitability.

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