Broker Check

Roth Conversions

March 26, 2021

Last week, Jim Sr. shared a few thoughts on how to approach the higher tax environment that's likely coming in 2022. With the national debt surpassing $28 trillion and a third covid stimulus package in motion, you should expect higher income taxes and capital gain rates in the near future.

His post mentioned an important concept, Roth conversions, which I want to expand on. 

A Roth conversion doesn't make sense for everyone, especially those who are in their peak earning years and are taxed at a high marginal tax rate. But for those currently in the 24% marginal tax bracket or lower, it can be a powerful strategy that involves paying less tax now rather than more tax in the future.

Before we go further, take a minute to refresh on the benefits of traditional and Roth retirement accounts:

While these accounts all provide tax benefits, determining when you receive that tax benefit is very important.

With a traditional 401k/IRA, you receive a tax benefit upfront when you contribute (i.e. if your income is $50,000 and you contribute $6,000 to a traditional IRA, your taxable income becomes $44,000). When you withdraw money from that traditional IRA later on, you'll pay taxes.

With a Roth 401k/IRA, you don't receive a tax benefit when you contribute. Instead, you receive the tax benefit on the back end when you withdraw. 

Ok, now the fun begins (I am very clearly joking but this is important). A Roth conversion takes place when someone converts existing traditional 401k/IRA money to a Roth 401k/IRA. Because that money is moving to a Roth account which provides no upfront tax benefit, taxes must be paid on the converted money at the individual's given tax rate.

Here are three reasons to consider a Roth conversion this year:

  1. With tax rates likely increasing next year, you may be taxed at a lower marginal rate this year. Paying the conversion tax now would be short-term pain for long-term gain.
  2. After converting to a Roth, the earnings component going forward does not get taxed again, assuming you follow the rules. This is a powerful benefit given the uncertainty of the tax code going forward.
  3. Roth IRAs do not have required minimum distributions (RMDs). Converting funds from a traditional qualified account to a Roth IRA ultimately lowers the RMD amount required to be withdrawn from that traditional IRA starting at age 72. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.

To get an idea of whether a Roth conversion might make sense for you, estimate which marginal tax bracket you may fall into 1) during the year of conversion vs. 2) when you expect to withdraw from the account (Keep in mind that marginal tax rates are likely to increase next year, but your income may not depending on your career and other circumstances). If you think you'll be in a lower tax bracket during conversion as opposed to when you withdraw, consider converting some funds to a Roth account and taking the tax hit now. If you think you'll be in a lower tax bracket in the future when you withdraw funds, leaving that money in the traditional IRA may be the better option.

Again, a Roth conversion is not for everyone and it depends on your own financial situation and tax bracket. But if you're looking to position your finances for the rising tax environment that's likely coming, it'd be smart to consider.




Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. No strategy assures success or protects against loss. Investing involves risk including loss of principal.