2020 has been a popular year to have the conversation about converting a Traditional IRA into a Roth IRA. This process involves transferring your Traditional IRA funds into a Roth IRA and paying taxes on the amount transferred. This article will help you understand the benefits and drawbacks of this conversion.
Long-Term Income Tax Savings
Let’s first discuss and understand the basic differences between these types of accounts. With a Traditional IRA, you take a tax deduction when you make contributions to the account. This means that you reduce your tax liability each year that you make contributions. Your money then grows tax-deferred, meaning you don’t pay income taxes while the account is increasing in value. When you pull the money out, you pay income taxes on the entire withdrawal regardless of how much you put in and how much you had in investment gains. The idea with a Traditional IRA is that some individuals expect to be in a lower tax bracket during retirement. They would rather pay taxes during this time and take tax deductions during their working years, where they may be in a higher income tax bracket.
With a Roth IRA, you do not take deductions as you contribute to the account. This means that you are putting “post-tax” dollars into the account. The investment gains are still tax-deferred, meaning you don’t have to pay income taxes as the account increases in value. The biggest difference is that when it is time to pull the money out during retirement, you do not pay taxes on ANY portion of the withdrawal. This essentially means that any investment gains you may have in the account are never taxed. If you expect to be in a similar or higher tax bracket during retirement, this option may make more sense for you.
Tax Rate Uncertainty
Another reason many individuals are having the conversion conversation this year is because there is some uncertainty as to how long we will be in the low-tax environment we are currently in. The Tax Cuts and Jobs Act decreased marginal tax rates to historically low percentages in 2018. With the election in 2020, there is some uncertainty as to how long these low rates will be available.
With that in mind, it may make sense for some individuals to bite the bullet and pay some taxes this year to take advantage of possible future tax savings when tax rates may be higher. However, it is important to understand how the conversion process works to make sure you can afford the taxes that may come due at the end of the year.
Immediate Tax Consequences
Before evaluating the Roth IRA conversion, it is critical to understand how the process works and the tax implications of converting. In order to do a conversion, you must have a Traditional IRA set up already. If you have an old 401(k) that you want to convert, you can start by rolling these funds into a Traditional IRA. After that, you’ll have to open up a Roth IRA. From there, you can move the funds from the Traditional IRA into the Roth IRA.
When you do this, you will have to pay taxes on the full amount of the funds converted in the current year. This means you’ll have to have some money set aside to pay the taxes. You can’t just withhold taxes from the conversion, because the amount you withhold will technically be a normal distribution instead of a conversion. If you have a large amount to convert, this may be a significant check you’ll have to write to the IRS at the end of the year. If this is already a high-tax year for you, it may be worth considering converting some of the funds this year and more in future years. Doing too much in one year may increase your marginal rate and decrease the net benefit of doing the conversion.
Converting to a Roth also doesn’t make sense for everyone. Make sure you consult with your tax and accountant and financial advisor to make sure it is the right choice. For example, conversions might not make sense for some older investors who may need access to the funds in the near future. Since the main benefit doing a conversion is avoiding income taxes on investment gains, it makes more sense for someone with a longer investment horizon who is more likely to see the account increase in value. If an older investor needs access to the funds within the next 10 years or so, market fluctuations could cause a decrease in value. This would mean that the investor may pay more taxes on the conversion than if they left the funds in the Traditional IRA.
Lack of Flexibility
Be aware of the 5-year for Roth IRAs. When you do a conversion, you must set these funds aside for at least 5 years before drawing from them. If you draw from the account before that, you may be penalized on your taxes. This penalty is 10% of the amount withdrawn plus income taxes on any earnings in the account. Younger investors that are further from retirement should not have to worry about this, but there are situations that can arise where you may need access to the funds. Before doing a conversion, make sure all of the money you are converting can be set aside for at least 5 years.
Before converting your Traditional IRA into a Roth, just be sure to plan for the taxes due and the temporary lack of access to the funds. If you are considering a conversion and want to know how much money to set aside for taxes, contact me! I offer free consultations to new clients and tax projection services that can help you plan for the additional taxes that may be due