Five Reasons Why You Should Convert to a Roth IRA

We should always strive to make informed financial decisions that will enhance our long-term financial security. With regard to retirement planning, one decision that requires careful consideration is whether to convert a traditional Individual Retirement Account (IRA) to a Roth IRA. Converting to a Roth IRA, also know as a "backdoor Roth", could provide substantial financial planning and tax benefits, but it's not always the right move for everyone depending on your financial circumstances. It's important that you have your financial advisor or CPA run the numbers to determine what's best for you. Here, we'll delve into the intricacies of Roth IRA conversions and outline some of their potential benefits.

What is a Roth IRA Conversion?

A Roth IRA conversion is a process where a traditional IRA, Simplified Employee Pension (SEP) IRA, or a Savings Incentive Match Plan for Employees (SIMPLE) IRA, is transferred into a Roth IRA. This process also applies to a rollover from a qualified retirement plan, like a 401(k). When you convert to a Roth IRA, the amount converted (minus any after-tax contributions) is treated as taxable income in the year of conversion. However, this initial tax burden can open the door to significant long-term tax benefits. As a general strategy, this strategy should be executed once your AGI exceeds $138,000 (218,000 Married Filing Jointly) as you cannot make normal Roth contributions above these thresholds.

Why not just contribute to a Traditional IRA?

Making contributions to a traditional IRA is an excellent way to save for retirement. You get a tax deduction for Adjusted Gross Income (AGI) up to $6,000 ($7,000 for filers over age 50). This can be a quick and easy option for self-employed individuals to sock some dough away for retirement while receiving a tax break for it. However, there are income limitations for taxpayers covered by retirement plans through their employer. For Married Filing Joint taxpayers with both spouses covered by a retirement plan, the deduction phase-out begins at $116,000 AGI ($218,000 if one spouse is not covered). Single taxpayers' phase-out begins at just $73,000. Bottom line, you don't have much runway to make tax-deductible contributions to your IRA before you hit these phase-out limits.

It somewhat nullifies the conventional wisdom that "you should contribute to IRAs at higher incomes for tax savings". While that sounds good in theory, you're not exactly "high-income" as a married couple making $116,000 by today's standards. Keep in mind that this does not mean that you *can't* make contributions to an IRA, it just means that you're not receiving the benefit of a tax deduction.

Five Reasons to convert to a Roth IRA.

1. Your Investment Gains are Tax-free

One of the primary benefits of a Roth IRA is that withdrawals in retirement are tax-free, assuming you're at least 59 1/2 and have had the Roth IRA for at least five years. This is a stark contrast to traditional IRAs, where withdrawals are taxed as ordinary income. While you may take a tax hit on the initial rollover from a tax-deferred account, the appreciation on your investments inside the account grows tax-free.

Tax-free withdrawals can be a significant benefit especially if you expect your tax rate to be higher during retirement than it is today. In essence, by converting to a Roth IRA, you're choosing to pay taxes now to avoid paying potentially higher taxes later.

2. No Required Minimum Distributions

Traditional IRAs have a feature known as Required Minimum Distributions (RMDs). Once you reach the age of 72 (this will most likely increase with future legislation), the IRS mandates that you start withdrawing a certain amount from your IRA each year, potentially pushing you into a higher tax bracket. The penalties for doing so can be harsh for not complying with this requirement as well. If the distributions to you in any year are less than the RMD for that year, you are subject to an additional tax equal to 25% of the undistributed RMD (reduced to 10% if corrected during a specified time frame).

In contrast, Roth IRAs do not have RMDs during the owner's lifetime. This allows your investments to continue growing tax-free for as long as you live, providing a potential source of tax-free income for you and your beneficiaries.

3. Estate Planning Benefits

From an estate planning perspective, Roth IRAs can be advantageous. Since Roth IRAs don't require withdrawals during the owner's lifetime, they can grow tax-free for a longer period, potentially increasing the value of your estate. Moreover, while your beneficiaries will have to take withdrawals, those withdrawals will generally be tax-free. In the case of estate tax, converting to a Roth IRA before death puts the tax liability on you instead of the 40% estate tax if you exceed the lifetime exclusion amount.

4. You're In The Conversion "Sweet Spot"

There's a financial planning "sweet spot" for a Roth IRA conversion. It usually applies if you're currently in a lower tax bracket but expect to be in a higher one in the future. This situation can occur if you're experiencing a low-income year, or if you believe tax rates will rise in the future. For example, you have favorable tax attributes which include a high cost basis ratio on assets or investments sold during the year, charitable deduction carry-forwards, investment tax credits, net operating losses (NOLs), etc. Bottom line, if you expect lower income than normal, and thus, a lower tax liability, making a Roth conversion in that year will most likely be beneficial.

5. Greater Tax-Free Yields

Allow me to ramble a bit before making my larger point here. If you contributed post-tax dollars to an IRA and did not receive a tax deduction, then you will not owe income tax on the portion of the withdrawal that is a return of your original after-tax contributions. However, you will still owe tax on the earnings portion of the withdrawal. In other words, you pay taxes on the interest, dividends, and capital gains that your contributions have generated over the years.

For a Roth IRA, you contribute after-tax dollars, but both the contributions and earnings can be withdrawn tax-free once you've met certain conditions (being at least 59.5 years old and having had the account for at least 5 years).

Like I mentioned earlier in this post, individuals that run into this dilemma likely exceed the thresholds mentioned earlier in this post, and they cannot make contributions to a Roth but can still make non-deductible contributions to an IRA. In this scenario you would most likely benefit from doing a backdoor Roth IRA contribution. This is done by making a non-deductible IRA contribution, and then converting that IRA contribution amount into a Roth IRA.

This is done for the purpose of being able to withdrawal the appreciated funds from your Roth, in retirement, tax-free. In summation, you're going to enjoy greater yields on your investments by not having to pay tax on the appreciation of your funds as you would with a traditional IRA.

Bonus Points to Consider

Income tax rates are historically low and have been dropping for the last 40 years or so. While any planner shouldn't attempt to predict what the future legislative landscape might look like, this does not mean rates won't increase in the future, so it might be a good idea to take advantage of the current rates. Additionally, Roth IRA distributions are not subject to the extra 3.8% Net Investment Income Tax, which is triggered when your Modified AGI exceeds certain thresholds. Finally, distributions from a Roth IRA are not considered taxable income for purposes of computing the limits on the 199A Qualified Business Income (QBI) Deduction. This would be beneficial for business owners who may exceed this threshold and want to take full advantage of the QBI deduction.

Conclusion

Converting to a Roth IRA can provide significant financial planning and tax benefits. However, it's important to consider all aspects before making the conversion. Remember, the conversion will increase your taxable income for the year, potentially pushing you into a higher tax bracket.

As always, it's recommended to have your financial advisor or CPA run the numbers before making any significant financial decisions. They can provide personalized advice based on your current financial situation and future retirement goals.

In essence, Roth IRA conversions can be a powerful tool in your retirement planning arsenal. By understanding the potential benefits and the right timing, you can make a more informed decision about whether this financial move is right for you. For more insights, and the latest tax and financial news, please subscribe to our newsletter!

IMPORTANT DISCLOSURES AVL CPA Firm, LLC. does not provide investment, tax, legal, or retirement advice or recommendations. The information presented here is not specific to any individual's personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.