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Roth Conversion Strategies: Everything You Need To Know

Posted by Jim Kantowski, CFP®, CPA on January 26, 2021

Roth conversion strategies - everything you need to know

Finding opportunities to reduce the amount of tax you pay is an integral part of financial planning. Converting your investments from an Individual Retirement Account (IRA) to a Roth IRA is one way to potentially decrease your tax burden.

In this guide to Roth conversion strategies, we’ll cover how Roth IRAs differ from traditional IRAs, and we’ll define Roth conversions. We’ll also highlight five Roth conversion strategies that may work for you depending on your personal financial situation and discuss the best time to explore these options.

Are you looking for help minimizing your tax bill? Schedule a call with Bay Point Wealth today to speak with an expert.

How Roth IRAs And Traditional IRAs Differ

What is a Roth IRA?

A Roth IRA is considered a post-tax investment account because you pay tax on the money you initially deposit into the account, then the funds grow tax-free, which means you don’t pay tax on money you withdraw from the account. What’s not to love about that?

This type of account is an ideal choice if you’re in a lower tax bracket when you open the account and begin contributing to it, and if you’ll likely be in a higher tax bracket at the time you withdraw your money, which you can begin doing at age 59½, as long as the account has been open for for at least five years.

Note that Roth IRAs do have contribution limits, which dictate how much money you can contribute based on your gross income, so don’t start hoarding your cash just yet.

What is a Traditional IRA?

A traditional IRA is a common alternative to an employer 401(k) retirement account. When you open an IRA and start contributing money to it, you can defer the tax on the deposits until you withdraw the funds later in life.

This type of account is a good fit if you’re in a higher tax bracket when you open the account than you expect to be when you need to withdraw your money. If you make a withdrawal from the account prior to age 59½, you’ll pay a 10% penalty—in addition to the income tax you’ll be required to pay on the withdrawal.

You can start making penalty-free withdrawals at age 59½, and you must begin making withdrawals—referred to as required minimum distributions—at age 72.

What is a Roth IRA conversion?

A Roth IRA conversion is a transfer of assets that involves withdrawing money from your traditional IRA, converting the funds into a Roth IRA, and paying tax on the amount you convert. Your money will then grow tax-free in your Roth IRA. It really is as easy as one, two, three.

Anyone of any age and income level can convert a traditional IRA to a Roth IRA. However, this kind of conversion is a better fit for some individuals than for others depending on personal financial circumstances, which we’ll discuss later in this guide.

6 Roth Conversion Strategies You Need To Know

Now that we’ve explained the differences between a Roth IRA and a traditional IRA, and covered the basics of a Roth IRA conversion, let’s explore six Roth conversion strategies that can help you with financial and tax planning.

Roth IRA Conversion Strategies

1. Decrease Required Minimum Distributions

If you convert funds from a traditional IRA to a Roth IRA before age 72, you may be able to reduce the required minimum distributions from your traditional IRA at age 72. Then, there will be less money in the account since you will have converted some or all of it to a Roth IRA.

This is an effective strategy because the money you withdraw from an IRA is taxable, so it’s best to reduce the amount in this account through a Roth conversion if you can. There are no required minimum distributions associated with Roth IRAs while you are living, which allows for your funds to grow tax free for a longer period of time.

2. Take Advantage Of Low Tax Rates

As we mentioned earlier, you do have to pay tax on the money you convert from your traditional IRA to your Roth IRA. After all, there’s no escaping the tax man. However, if your tax bracket is likely lower now than it will be in the future, it makes sense to do a Roth conversion and take the tax hit now, rather than later. This opportunity may arise if you lose your job, your business has an unusual financial setback, or if you retire early.

The alternative? Keep your money in your traditional IRA and risk being taxed at a higher rate when you eventually withdraw the funds if your income increases. No thanks!

3. Diversify Investments

Opening a Roth IRA means you have one more pot of money to contribute to and draw from than you had before. This gives you the flexibility to choose the accounts from which to make withdrawals at different times—and in different income brackets—during your life. A Roth IRA also offers you a greater ability to take advantage of tax savings opportunities.

For example, it’s best to keep stocks, such as exchange traded funds that have a higher potential return, in a Roth IRA for tax planning purposes. On the other hand, if you own bonds, you may be better off holding them in a traditional IRA.

4. Grow Assets (Tax-Free)

A seasoned financial advisor should take the most aggressive assets you own, such as high growth stocks, and hold those investments in a Roth IRA. As a result, you’ll have the opportunity to benefit from greater tax-free appreciation. However, keep in mind that asset growth is a long game, not a get-rich-quick scheme. It’s important to be patient and stay the course for this to pay off.

In addition, if you expect to be in a higher tax bracket later in life, you don’t want to saddle yourself with a hefty tax bill when it comes time to withdraw money from your retirement account. Another benefit of letting your assets grow tax-free in a Roth IRA is that you’ll have access to the full amount when you withdraw the funds.

5. Pass Wealth To Future Generations

Because there are no required minimum distributions associated with Roth IRAs while you are living, these accounts provide the flexibility to ensure you’re passing on as much of your wealth as you can to your loved ones. The SECURE Act, which was passed in 2019, changed the way IRAs are required to be distributed when inherited by a non-spouse beneficiary. In the past, your beneficiary could distribute the assets over their lifetime, which was called a stretch IRA. Now, they must distribute the assets within 10 years.

For example, if you pass on an IRA worth $1,000,000 to your 30-year-old child who is a high earner, a big portion of the IRA could go to taxes, since the time period for withdrawal of the funds has been condensed to 10 years. Although a Roth IRA also has to be distributed over 10 years, it will be tax-free and therefore will not be taxed on top of the child’s income. If you don’t plan on using the money in your IRA, and you get a sense that your retirement income is lower than the beneficiary’s, a Roth conversion likely makes sense.

Roth Conversion Considerations

When does a Roth conversion make sense?

If any of the Roth conversion strategies we’ve discussed sound like a fit for your financial situation, then the best time to do a Roth conversion is now. The longer you have your money invested in a Roth IRA, the more you’ll benefit, because your wealth will be able to grow tax-free for a greater amount of time.

On the flip side, if you’re older and expect to have a few low income years in the near future, now is still an ideal time to do a Roth conversion—especially if you anticipate climbing into a higher tax bracket again later down the road.

When does a Roth conversion not make sense?

There are a few instances when we wouldn’t advise implementing Roth IRA conversion strategies. For example, if you are on Medicare and you do a Roth conversion, it could cause your premiums to increase because the funds you convert from a traditional IRA to a Roth IRA will have to be included on your tax return as income.

In addition, if you currently earn a lower income, your Social Security benefits may not be taxable. However, a Roth conversion could cause you to exceed the income limit and have your Social Security benefits taxed.

In both of these cases, if you have capital gains during the year, you could create extra tax for yourself if the income from the Roth conversion moves you out of the 12% tax bracket.

Get Tax Planning Advice From Bay Point Wealth

At Bay Point Wealth, we love talking about Roth conversions and other strategies that can save you money at tax time. We always take a big picture approach to financial planning that includes proactive tax planning.

Our team of Certified Public Accountants and Certified Financial Planners understands the importance of working with you to understand your unique financial circumstances, so we can help reduce your tax burden.

Schedule a call with us today to see how our team of experts can help find you tax savings.

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Topics: Financial Planning