Impact – Wealth Management


Should I Consider a Roth Conversion?

Have you discussed a strategy for converting the funds in your IRA to a Roth IRA with your financial advisor?

If you haven’t, you should.

Roth conversions are NOT for everyone, but a well thought out tax plan is an important component to a comprehensive retirement plan.  If your financial advisor is not engaging you in comprehensive planning, it might be time to find a new one.

Roth IRA Basics

First things first, let’s quickly understand what a Roth conversion actually is. In simple terms, it refers to the process of moving your money from a traditional retirement account (such as a 401(k) or a traditional IRA) into a Roth IRA.

The main difference between these two types of accounts is when and how they are taxed.

With a traditional account, you get a tax deduction when you contribute to the account, but you’ll have to pay taxes when you withdraw the money in retirement.

On the other hand, with a Roth IRA, your contributions are made with after-tax dollars, but your withdrawals during retirement are tax-free.

It’s hard to beat tax free withdrawals!  The catch is that when you convert money from an IRA to a Roth IRA, the amount that you convert is taxable in the year you do the conversion.

So when might it be a good idea to consider a Roth conversion?

Here are a few scenarios where it should be considered:

1. Tax rates are expected to increase:

Our current tax structure is going to “sunset” at the close of tax year 2025.  That means that unless Congress acts, the tax brackets will be changing back to the 2017 brackets, and taxes will be going up for many Americans.

If you believe that tax rates are likely to rise in the future, it might be a good idea to convert your traditional retirement account into a Roth IRA. By doing so, you’ll pay taxes on the converted amount at the current lower tax rate.  This allows you to potentially save money in the long run.

2. You have a low-income year:

Let’s say you’re taking a year off work, transitioning between jobs, or you have a low profit year as a business owner. Whatever the reason, if your income is unusually low, seizing this opportunity to convert some of your traditional retirement funds into a Roth IRA can be a smart move. Since you’re in a lower tax bracket, you’ll pay less in taxes on the conversion than you would in higher income years.

3. You have a long time horizon:

Roth IRAs offer a unique advantage – they have no required minimum distributions (RMDs) during your lifetime. If you have a long time horizon and don’t anticipate needing to tap into your retirement savings early, converting to a Roth IRA can allow your money to grow tax-free for as long as possible.

4. You want to leave a tax-free inheritance:

If you’re planning to pass on your retirement savings to your loved ones, a Roth IRA can be a fantastic option. By converting your traditional account to a Roth, you’ll leave behind a tax-free inheritance.  Your beneficiaries won’t have to pay taxes on qualified withdrawals from the Roth.

If your goal is to pass on as much money as possible to your heirs, then you may want to consider the estimated tax brackets of your heirs as well as your own tax bracket.

5. You want more control over your retirement income:

Converting to a Roth IRA can provide you with greater flexibility when it comes to managing your retirement income.

As a financial advisor, I can’t tell you the number of times that a client has come to me with a big dream that dies when we consider the taxable consequences of the withdrawal they would need.  The tax consequences of a large withdrawal can be significant and can even affect the price you pay for Medicare.

Since Roth withdrawals are tax-free, you have more control over the amount and timing of your withdrawals.

6. You have a large IRA:

Your IRA will eventually be subject to Required Minimum Distributions (RMD’s).  That means, when you reach the magic age, the IRS will require you to start taking taxable withdrawals from your Traditional IRA.  The IRS uses an equation to calculate the amount of your RMD.  It is the value of your IRA on December 31st of the prior year divided by your life expectancy (based on the Uniform Lifetime Table).

I have seen many clients skate through the first few years of retirement, enjoying relatively low income tax only to be surprised by a drastic increase in taxes when they reach RMD age.

A good tax strategy will help you determine when and how much you should be converting from your Traditional IRA to even out your tax burden.  Depending on your situation, this strategy can potentially save you hundreds of thousands of dollars in taxes over your lifetime.

Roth conversions can be done in any amount over the course of several years.

Each Situation is Unique

While these scenarios provide a good starting point, it’s important to remember that everyone’s financial situation is unique. It’s crucial to consult with a qualified financial advisor and that they work in concert with your tax professional.  Then they can assess your specific circumstances and help you make an informed decision.

At Impact Wealth Management, we routinely do tax planning with our clients in the fall of each year.  This helps ensure that our clients have a good handle on the income they can expect for the year and we have enough time before the year closes to execute the strategy.  Doing Roth Conversions too early in the year can be dangerous since income can sometimes change unexpectedly as the year unfolds.

Don’t put off tax planning.  Talk with your financial advisor about it today!

Impact Wealth Management LLC is a fee-only Registered Investment Advisor (RIA). We are based in beautiful Sioux Falls, SD and regulated by the State of South Dakota. Throughout this site, we went out of our way to present unbiased data believed to be from reliable and respected sources. However, its accuracy, completeness, and relevance are not guaranteed, and no responsibility is assumed for errors or omissions.  Tax law and individual situations change often.  Always consult your tax and financial professionals before implementing a Roth conversion strategy.