When planning for retirement, there are a lot of things to consider. One element that plays a major role in these decisions is taxes. Questions such as whether you pay taxes now or later, how much you pay and if there’s any way you can reduce that tax burden will go a long way towards what retirement planning you opt for.
One move that many have made and found helpful is a Roth IRA conversion. Doing this can help some people pay less in the long run and can have other benefits as well.
What Is a Roth IRA Conversion?
A Roth IRA conversion is when you take an existing retirement account – whether it be a traditional IRA, 401(k) or SEP – and moving the funds into a newly-created Roth IRA account. This action creates a situation where you have to pay taxes now. However, on the other hand, doing this means you don’t end up paying taxes later on when you start to draw from the account. This can be a good move for younger people and those who expect to remain in the same, or even higher, tax bracket as they begin to draw from their IRA. Plus, you don’t pay tax on the growth! Ultimately, the taxes you pay now are less than what you would have paid otherwise.
What Is the Difference?
It can be difficult knowing what is different about these various accounts, but it usually boils down to one thing: taxes. In this case, the difference between a Roth IRA and other accounts is when you pay your taxes. With tax-deferred accounts, you don’t pay taxes when you contribute, but you do pay taxes on earnings and when you draw from them in retirement.
Roth IRAs, however, are tax-exempt. This means that you pay taxes when you first contribute, but you do not owe taxes when the account grows. Simply put, every penny comes out tax free.
Benefits of Conversion
As mentioned earlier, there are several reasons why someone might consider doing a Roth IRA conversion.
The main reason why someone might want to opt for this is that it can lower your tax bill in the future. True, the conversion itself will come with a tax bill that will have to be paid first. But after that, everything that comes out of the Roth IRA is tax-exempt.
A second advantage is that Roth IRAs allow you to keep money in your account for as long as you want, unlike traditional IRAs that require you to start withdrawing money at a certain age known as a Required Minimum Distribution (RMD).
Disadvantages of Conversion
Even though there are plenty of reasons to consider a conversion, they aren’t all pros. There are cons as well.
The first, and most important, is the tax bill that comes with the switch. In pre-tax accounts, the money sitting in those accounts to date has not yet been taxed. When converting, the taxes are owed on however much is moved over. In some cases, this can be a significant amount of money, and for many it is a huge deterrent. However, remember that we’re going for long-term benefits here, not short-term.
Another disadvantage, is that Roth IRAs require the money to be untouched for at least five years, and similar to traditional IRAs, you must be at least 59 ½ before you can access those funds.
Backdoor Roth Conversions
This is tremendous opportunity that allows you to make a non-deductible contribution to an IRA and then do a full Roth conversion on these dollars. You then pay tax on any growth in the account. For example, let’s assume you have no IRA accounts to date. You make a $6,000 non-deductible IRA contribution on 1/1/2022. On 7/1/2022, the balance has grown to $7,000. You do a full Roth conversion and pay tax on the growth of $1,000. You now have $7,000 in your Roth IRA and when you pull those dollars out in the future, they will be 100% tax free.
Please note that due to the pro-rata rule, it is important to not have any other IRA balances when doing a backdoor Roth conversion. The IRS will take all of your IRA balances into account, and then determine the percentage of the conversion that is going to be taxable. If you have several IRAs with large balances, the backdoor Roth conversion isn’t for you. One way to avoid the pro-rata rule is if you have a 401(k) account. If you roll your IRA accounts over to your 401(k) account, you don’t have to consider any additional IRA balances when doing the backdoor Roth conversion. This is a win-win all around.
Of course, this is only scratching the surface of Roth IRA conversions and backdoor Roth conversions. If you any questions on how these strategies work, please reach out to one of our advisors at JDH Wealth and we can walk you through the process.