Roth conversions are a great strategy that you can use to help build up your “tax-free” bucket in order to provide you with more flexibility in retirement. Having more tax-free money can help you avoid tax time-bombs, maintain some control of your taxable income in retirement, or even be used as an excellent legacy to pass down to heirs. In this episode we talk all about how Roth conversions work.
More specifically, I discuss:
- Our upcoming “Retirement Planning Today” classes in February 2023
- The main differences between a Roth IRA and Traditional IRA or other pre-tax account
- What is a Roth conversion?
- What are the main reasons to consider doing a Roth conversion?
- Pitfalls to look out for when doing a Roth conversion
- Strategies on how to pay potential taxes owed on a Roth conversion
Resources From This Episode:
Blog: Roth 5-Year Rules
Flowchart: Should I Consider Doing A Roth Conversion?
Related Episode: https://retiredishpodcast.com/6
What is a Roth conversion and Why Should I Consider It?
Hello, and welcome back to the Retired-ish podcast. I'm your host, Cameron Valadez, and today we are going all the way from the basics to the nitty gritty into a popular strategy known as a Roth conversion.
But before we get into that, I want to talk about a couple of important things. The first being our upcoming online comprehensive retirement planning classes taking place next month in February, taught by yours truly. My firm teaches these classes a couple of times a year, and they are purely educational. We go over many of the concepts this podcast is all about, from setting up your budget in retirement to the different types of accounts, strategies that you can explore, investments, taxes, estate planning, Medicare, social security, and much, much more.
However, because this is a classroom type of setting and we will be spending a good amount of time together, we are able to give you stories and share some real-world experiences, not just the same old stuff you read online every day on investing or retirement websites. You also get the chance to ask questions about whatever is on your mind during the classes.
Our program is actually broken up into three different classes. The first two are conducted online via Zoom, and they're about two hours each class. You attend from the comfort of your own home with your favorite food and beverage of choice, and you can even be on your couch for all we care. Then we conduct a third class, which is a one-on-one lab session with you via Zoom or in person if you'd like to show you how to put together what you learned and show you how you might apply it to your own situation, which is the best part, in my opinion, because it makes it that much easier for you to actually implement, which is the important part.
We all do it. We sign up for webinars. We read articles and books on something. We go on Google for hours to learn about something, and we may actually end up learning a lot about the thing that we're looking into, but then we do nothing about it, which literally means all we did is succumb to a bunch of content that distracted us from our daily lives and wasted our time. Right? Because if you don't act on what you've learned, it's meaningless. We gotta do something about it.
Okay, so it's important to understand that these classes are a little bit of a time commitment, and so they're only for those serious about their retirement planning. Again, you will be learning stuff you likely aren't reading about or maybe aren't getting the full story on. So, naturally, there is a cost. The cost to attend all three sessions is $49. That's it. You will also receive a downloadable workbook, which has a lot of retirement content in it, and you get to keep this book and refer back to it whenever you may need it. Included in the cost, you may also have a spouse or a guest attend with you.
To find the dates available and links to register, see the show notes for today's episode on your podcast app or visit Retired-ish podcast.com/ten. If you're a current subscriber to the retired newsletter, you have already received the details in the January newsletter, so if you missed those, go back and check that out.
The other important thing I wanted to mention really quick before we get started here is that as of January 1st, 2023, we now have a slew of new retirement legislation that went into effect due to the passing of the Secure Act 2.0. This recent legislation has introduced nearly a hundred different changes to current retirement-related laws, a lot of which affect people just like you. Some of the changes are in effect now, whether you knew it or not, others not until next year, and some even a whole decade from now. We have been hard at work understanding these new changes and will be releasing an episode soon on some of the most important ones and how they may affect you. So be on the lookout for that episode so you can stay up to date with your retirement planning endeavors.
Okay, now, onto today's show. As I mentioned today, we are talking about Roth conversions, starting from the basics. So first, what is a Roth IRA? A Roth IRA is a particular type of retirement account that is funded with money you've already paid taxes on. These are called your contributions. Then as long as a couple of simple rules are met, the interest earned on the investments in the account can be earned free of taxation. Because the money contributed was already taxed, and the earnings are eligible to be tax-free, all of the money is generally tax-free when taken out in retirement.
Now because the money contributed to a Roth has already been taxed, you can also always withdraw an amount equal to your contributions, tax-free, no harm, no foul, even before age 59 and a half, although I don't encourage that since the money is for retirement, not a short-term savings account. However, either way, it's a nice feature.
There are also other versions of Roth accounts out there, such as Roth 401(k) accounts, Roth 403Bs, Roth 457s, just to name a few. And now, since the Secure Act 2.0 has passed as of 2023, there are actually Roth SEP IRAs and Simple IRAs allowed as well. However, as of today, I don't know of any custodians out there that have developed the paperwork and the legalities necessarily to create one of these yet.
And as a side nerd note, the new Roth SEP IRA rules aren't necessarily groundbreaking since before 2023, you could essentially fund a regular SEP IRA and then convert the entire contribution to a Roth IRA anyways, which is essentially the very concept we are discussing today.
In addition, it's also worth noting that Roth IRAs do not have those pesky required minimum distributions, aka RMDs, later in life, whereas pre-tax accounts like traditional IRAs or 401(k)s and the like do. In fact, starting in 2024, thanks again to the Secure Act 2.0 that just passed, plan-based Roth accounts such as those Roth 401(k)s, Roth 403Bs, and Roth 457 plans will no longer have RMDs either. Currently, these plans, although they are Roth accounts, are subject to RMDs at your required beginning date.
Okay, so why not only fund a Roth account since tax-free sounds better than giving money to Uncle Sam? Well, the first step is to compare funding a Roth versus funding a pre-tax account such as a traditional IRA. In general, the main difference between a Roth IRA and a traditional IRA is that when you fund a traditional IRA, you have the ability to receive a tax deduction for the amount contributed for the year of the contribution. Any potential interest earned will be tax-deferred and taxed at ordinary income tax rates when you take it out later in retirement. So, as it earns interest year to year, you're not going to pay taxes on that, but the day you take money out of the account, you will pay full bow and taxes on whatever you take out.
Therefore, because you receive a tax benefit today in something like a traditional IRA, you will pay taxes on the contributions and earnings when the money is taken out. To cut to the chase, the decision comes down to whether or not it makes sense to pay taxes now or later based on your tax rate at each given period of time. And to make that decision, you have to make your best guess as to whether either one, the tax rates will be higher when you need to distribute money from the account in retirement to supplement your lifestyle needs versus your current tax rate. In this case, a Roth would win out over a pre-tax account if tax rates will be higher later when you need to take the money out.
Or two, your taxable income from all sources, including the withdrawals from your various accounts, will be lower in retirement, and therefore you will be in a lower tax bracket if we assume that tax rates will be exactly the same as they are today. If that was the case, a pre-tax account would have served you better than a Roth.
Now, this isn’t a very straightforward answer because the fact is that there is no way you will know for sure what tax situation you will be in, in retirement unless you are literally on the verge of retiring. There are too many factors in moving pieces, such as tax laws and rate changes, tax bracket changes, think, you know, like more the income ranges used in the given tax brackets. They can actually change, they can get smaller or bigger. Your retirement date or plans may change numerous times, and you may have a surprise expense come up that causes you to make a large withdrawal from your pre-tax accounts, which also might derail your tax situation entirely, such as causing you to have to pay surcharges on your Medicare premiums, just as one example. All of these factors and more play into whether or not you want to fund a Roth account.
So, what do you do? Well, because you don't know the future, and my crystal ball is broken, when someone asks me whether they should save in a traditional pre-tax account like a traditional IRA versus a Roth tax-free based account, my answer is both. In fact, I would also encourage saving in a third taxable account as well, which is essentially just a regular old investment account in your name or your trust that you fund with money that’s sitting around in your bank account, so it's just not a retirement account. You pay taxes on the earnings year to year as it earns dividends, or you incur potential capital gains and losses.
A combination of these three account types is likely to give you the most flexibility in retirement. When discussing the importance of having tax-free funds in a Roth, I typically explain it this way. One day, you are going to need a lump sum of money, and I hope it's for something really fun like an RV to travel the states and visit your children and grandchildren or something fulfilling like gifting money to your kids or helping pay for a grandchild's college education. However, it may just as likely be for something unexpected and not so fun, such as paying for an emergency medical expense or long-term care. But either way, when that happens, if you pull a ton of money out of a pre-tax account, like a traditional IRA all at once, you are going to get killed in taxes. So having some Roth money can help ensure against that potential issue.
Instead, you can eat the proverbial elephant one bite at a time so that in the future, when that situation comes up, and it will, it doesn't blow up your finances via a tax time bomb. The biggest issue here is that out of all the different account types, most people have very little in their tax-free bucket, let's call it, which is essentially Roth money.
One very viable and popular strategy for those that have already accumulated far more in their pre-tax accounts versus their Roth-based accounts or their tax bucket is to consider doing Roth conversions. In a nutshell, a Roth conversion is where you convert or move money that is in a traditional tax-deferred account, like a traditional IRA or 401(k), to a Roth-based account. Typically, this is pre-tax money that now becomes after-tax money once in the Roth. So, by definition, this means that you will pay taxes on the amount converted in the calendar year you convert. You are choosing to pay the tax bill now versus waiting until you take the money out of the pre-tax account down the road. And in exchange, you now have money in a tax-free investment vehicle.
Now I have to caveat that it is possible to have after-tax money in a traditional IRA or 401(k) and then convert that money, which generally wouldn't be taxable when you convert. Again because it's already been taxed, this is typically done when a high-income earner is utilizing another useful strategy called the backdoor Roth IRA, or in a 401(k) plan, it might be the mega backdoor Roth IRA strategy. However, for the purposes of this episode, we will assume that all of the money you may convert has not been taxed yet, and therefore the conversions will be taxable.
Now, the cool thing about Roth conversions is that there is no limit to how much or how little you can convert in any given year. Conversions are different than contributions to your Roth accounts, where there are limits to how much you can contribute each year. Whether it's a Roth IRA or a Roth-based account with your employer's plan, it doesn't matter. Said differently, Roth conversions are one of the primary ways to build large Roth account balances. Not only that but there are no income limitations that will disallow a Roth conversion either like there are with contributions. The government loves Roth accounts because they will get tax dollars today versus tomorrow, and that helps them out. Especially in this day and age. Politicians care about the budgets when they are in office.
Now, before you go looking into doing any conversions, there are a few things you'll want to understand before you do. The first is commonly referred to as the five-year rule or clock. There are actually two different five-year rules, one for contributions and one for conversions. And just so you know, we are discussing the five-year rule for conversions today. I will include a blog on these rules and how they apply to different situations in today's show notes. So be sure to look into that.
The five-year rule is used to determine whether or not the principal amount from a Roth conversion is penalty-free. For conversions, your five-year clock starts on January 1st in the year you first make a conversion to a Roth IRA. So, for example, if you make a $20,000 Roth conversion, let's say on September 19th, 2023, your clock for that converted amount is assumed to have started January 1st, of 2023. And yes, each conversion gets its own new five-year clock. However, this might not be an issue for you, depending on your situation.
But first, let me explain the purpose of this rule. This rule is in place to prevent somebody from trying to take money out of a pre-tax account like a traditional IRA before they reach age 59 and a half and avoiding a 10% penalty on the entire amount withdrawn. So, the principle and the earnings. It blocks them from trying to convert the money first and therefore paying taxes, but then avoiding the 10% penalty on it since in a Roth account, typically the principal or the amounts you've put in aren't technically subject to the 10% penalty if taken pre 59 and a half. Remember we talked about that? It's one of those cool features of a Roth. This rule makes sure that people can't circumvent that.
So, you're probably wondering, ‘Okay, but what if I'm over age 59 and a half?’ Well, in that case, it's kind of a moot point. Yes, the money technically has a five-year clock running, but you're over the age of 59 and a half, so you aren't subject to the penalty either way. If you have other Roth money in the account that is not from conversions, or maybe you have older converted money in the account, the order of operations per the IRS when you take distributions from a Roth IRA is this. It's after-tax contributions first, conversions second. If there's multiple conversions, it's the earliest conversion first, and so on, and the earnings last. It is important to know that there is no reporting from your investment custodian where your Roth account is that will report this for you. And when you go to make a distribution from it or a withdrawal, you're not able to dictate, ‘Hey, I want to take earnings, or I want to take my contributions.’ It's just an assumed order of operations. You will need to keep track of this stuff on your own. Again, your custodian is not going to have any reporting that tracks how you withdrew. They're just gonna show the amounts that you've withdrawn and when you did it.
The last thing to understand is that if you are at the age where you need to take RMDs or required minimum distributions, you must take your annual RMD before you convert any money from a traditional IRA or 401(k) to a Roth.
Okay. So, what are some of the primary reasons or advantages to doing a Roth conversion? Well, the first is, in general, to build up a larger tax-free bucket to provide you with more options in retirement. Again, most people's, let's call them asset buckets or tax buckets, are heavily weighted towards pre-tax dollars and very little tax-free. Secondly, if you have any after-tax money that has been contributed to a Roth 401(k) or traditional IRA for any reason, and you convert that money, this would be a non-taxable conversion if done properly. You don't have any other traditional IRA account balances by year-end. So, if you have any after-tax contributions in any of these accounts, it's almost a no-brainer to get that money converted to a Roth IRA. But you have to make sure you do it correctly.
Another reason is that if your income is too high to make a regular Roth contribution, in this case, you would utilize the backdoor Roth IRA strategy I mentioned earlier, which involves a Roth conversion of after-tax contributions. Therefore, again, be careful about having other traditional IRA account balances at year-end, or you will trigger some taxation on your conversion due to something called the Pro Rata rule.
Conversions can also reduce RMDs later in life since you'll be making your pre-tax accounts smaller after the conversion. This, in turn, will reduce your taxable income compared to what it could have been and keep you under some other important income thresholds, such as those for those pesky IRMA surcharges on Medicare premiums, just as one example.
If you want to make an excellent gift to your heirs, a Roth is generally the best way to do so. They will inherit money tax-free that's already in a vehicle that can continue to grow tax-free for 10 years after they inherit it. There's little to no other vehicles out there that can do so, and oftentimes this can be a larger amount than they themselves could ever put into a Roth due to their own limitations. They might only be able to contribute several thousand dollars a year to a Roth based on the annual limits. So, if you gift them a larger lump sum, they get a very nice benefit.
And lastly, some states may provide special income tax exemptions for amounts converted. Check to see if your state has any of those special exemptions that could be another reason to consider converting.
So, when are some good opportunities to look into converting? When should you consider it? The first is known as during your gap years or in your retirement window. And this is different for everybody, and there's different terms that the industry has for this period of time, but it's generally that period of time before you begin to take social security and maybe a private pension if you're eligible for one of those and or your required minimum distributions. So, it could be just before retirement or right after retirement, but you haven't started collecting those income streams yet, so your income is a little bit lower. So again, these are typically years where you have a lower tax liability than you will once those other income streams start to come in.
A second time period you could look at doing a Roth conversion might be where if you have a year or two where you have zero tax liability, nothing at all, or maybe close to it. So, you barely have any income that you're taxed on your tax return in any given year. Most people from the onset would think that if you had a year where you had zero tax liability, that it was a great year. When in fact, that's actually a terrible thing if you have pre-tax retirement money or other investments in taxable accounts with gains. The reason is that you could have converted up to a certain amount and not paid any taxes on the conversion, or at least paid a far lower rate than you normally would at any other time in your life. It's a wasted opportunity, and a Roth conversion is one way to take advantage of it. So again, don't waste a tax year with low or no tax liability.
And on another note, if your aging parents are in a situation like that where they have very little tax liability year to year, or they don't pay anything at all because they're getting mostly social security, you might want to help them look into that. If they have IRA money, educate them on this, and don't let them make those mistakes, either.
You will also want to convert during times when your investments inside your pre-tax accounts are down significantly in value due to poor market conditions. In this case, it may be wise to convert the shares of the investments that you already own, albeit at a lower price, so that you have a lower tax bill. And if the share prices eventually increase, again, they will do so potentially tax-free because now they will be in the Roth account.
Now that we've considered why Roth conversions may make sense and when might be some opportunistic times to consider them, let me provide you with some tax tips when it comes to paying any taxes owed on a potential Roth conversion. When it comes to taking care of the tax bill, you essentially have two options. You can pay for it out of pocket from money that's in your bank account or any other non-retirement account, or you can actually withhold taxes from the conversion itself. By opting to pay your taxes from a taxable account, which again is essentially just a non-retirement account, like a bank account trust, joint account, transfer on death account, and the like, this will allow you to convert the entire amount that you intended, and therefore you'll also have more money that goes into the Roth and is able to be invested on a tax-free and tax-deferred basis.
If, instead, you withhold taxes from the conversion itself, it will do two things, possibly three. The first is that it will cause less to go into the Roth to potentially grow tax-free. So, for simplicity's sake, say you convert $10,000 and withhold a total of 20% for taxes. Theoretically, $8,000 will go into the Roth, and the other $2000 will be sent to the IRS via withholding. Now the second thing is that if you had any non-retirement money in a taxable account that you could have used to pay the $2,000 in taxes rather than withholding it, that money if invested in that non-retirement account, will generate taxable income each and every year, which will impact its return in a negative way.
So again, for simplicity's sake, if that $2,000 left sitting in a non-retirement account made, say, 4% in interest or dividends, for example, that will be taxable in each year that occurs. When on the other hand, if you instead paid the $2,000 in taxes with that money, then you would have $2,000 more in the Roth IRA since you didn't withhold it, which will potentially earn interest tax-free and is tax-deferred anyways, so there is no tax bill year to year.
The potential third ramification will occur only if you convert funds when under age 59 and a half. The conversion itself is still not subject to a 10% penalty, but if you withhold extra money to pay the taxes, that extra amount will be subject to the 10% penalty since it's technically not a conversion, it's a distribution to pay taxes.
Now over a decade or two, paying the taxes out of pocket rather than from the conversion itself can possibly make an unbelievable difference due to compound interest over a long period of time. It's usually a better decision to pay the tax from a separate taxable account if you will owe additional taxes at all, which leads me to my next tax tips. That is, if you withheld extra income from any other income source during the year or you just have a habit of over-withholding to get a refund each tax season, you can have your tax professional do a projection for you on what your tax bill at the end of the year may look like before you do the conversion.
And if you are, in fact, getting a refund, which means you've already overpaid to an extent, that money can essentially go towards the taxes owed on your potential conversion. So, in some situations, you may not need to pay additional taxes after you do a conversion. If you make a large enough taxable conversion and decide to pay out of pocket for taxes, you should also consider making an estimated payment via mail or online to avoid potential underpayment penalties, as well as potential penalties for not paying in a timely manner throughout the year.
You can owe these penalties even if you get a refund come tax time. So don't be duped on that one. Doing this can also ease the potentially large tax bill due at the tax payment deadline in April by paying some of that bill ahead of time. My firm has a guide that shows you how to make an estimated payment online, which is better than mail, in my opinion, because we take out the possibility of the payment getting lost in the mail. I will put a link to that in today's show notes, so be sure to be on the lookout for that.
At the end of the day, you should always consult your tax and financial professional about a potential Roth conversion and definitely compare the possible outcomes of your overall financial situation with the possible outcomes of not doing any Roth conversions at all.
Now, I will warn you that when talking it over with your tax professional, there is a very good chance that they will give you some pushback. And there's nothing wrong with that. This has nothing to do with them or you being right or wrong but more so the fact that their industry has almost universally been all about kicking the tax can down the road as often as possible whenever possible. So, when you decide to voluntarily pay taxes now versus later, you will want to provide them with more context regarding your decision so that you can get on the same page. Or you can just have them collaborate directly with your financial advisor if you have one.
Getting a tax benefit today is nice via getting tax deductions and, again, kicking that can down the road. But when taking a comprehensive approach and looking at all of the other potential factors at play, paying now versus later may provide you with far more valuable benefits later in life.
That's it for today's show. If you have a minute and find this information actionable and insightful, and you wanna stay up to date on the latest and useful retirement planning content, please subscribe to or follow the show on your podcast app. If you'd like to learn more about the rules and strategies discussed in today's show, you can find the links to the resources we have provided in the show notes on your podcast app, or you can visit us at Retiredishpodcast.com/ten.
To help you plan for the new year, see today’s show notes as we are including our newest 2023 quick reference guide that includes the important numbers to know for 2023, such as retirement plan contribution limits, IRMA Medicare surcharge brackets, tax brackets, and more, so you can start planning for the new year.
For those of you serious about retirement, don't forget to sign up for our online retirement planning classes next month in February. The links and details to sign up are located as well in the show notes. You can also sign up for the monthly Retired-ish newsletter there as well, where each month, we discuss money and emotions, investing, tax, state tips, Medicare and Social Security, and even a brief discussion about the current markets in layman's terms.
We always include something actionable in our newsletters so that you can implement something right away, such as how-to guides and other simplified strategies. Again, this can all be found at Retiredishpodcast.com/ten. Thank you for tuning in and following along. As always, see you next time on Retired-ish.
Securities and advisory services are offered through LPL Financial, a registered investment advisor, member FINRA, SIPC. The opinions voiced in this podcast are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA.
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. Investing involves risk, including the potential loss of principle. No investment strategy can guarantee a profit or protect against loss. Past performance is not a guarantee of future results.
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Treasury inflation-protected securities, or TIPS, are subject to market risk and significant interest rate risk as their longer duration makes a more sensitive to price declines associated with higher interest rates. Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free, but other state and local taxes may apply. If sold prior to maturity, capital gain tax could apply.
Neither LPL Financial nor its registered representatives offer tax or legal advice. Always consult a qualified tax advisor for information as to how taxes may affect your particular situation.
Asset allocation does not ensure a profit or protect against a loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.