A Roth individual retirement account allows tax-free growth of retirement savings. It’s an attractive concept as it can help reduce your tax burden in retirement, a time when most people are limited in how much income they generate.
One drawback to a Roth IRA is that it’s only available to single tax filers who earn less than $161,000 or less than $240,000 for those filing jointly.
However, a mechanism known as the Roth conversion allows high earners to fund a Roth using money from a traditional IRA.
“A general rule of thumb is you should convert if you are in a lower tax bracket than you would be in retirement,” said Gloria Garcia Cisneros, a certified financial planner and wealth manager with LourdMurray in Los Angeles, in an email.
[READ: Deciding Between a Roth vs. Traditional IRA.]
Who Is Best Suited to a Roth Conversion?
A good time to perform a Roth conversion is after retirement but before you’re required to take required minimum distributions from a traditional IRA in your early 70s, said Garcia Cisneros.
“The idea is you can save lifetime taxes even if you are triggering taxes in that year,” she said.
Here’s how that works: When you transfer funds from a traditional IRA to a Roth IRA, you pay taxes on the transferred amount at your current income tax rate. Once you’ve made the conversion, the funds grow tax-free, and qualified withdrawals in retirement are also tax-free.
It’s not just new retirees who may be well served by a Roth conversion.
“Roth conversions are most suitable for those in lower income brackets,” said Maura Madden, a certified financial planner and founder of Maura Madden Financial Planning in Seattle, in an email.
“This may include career changers, those taking unpaid leave or temporarily unemployed individuals,” she added.
[7 Things to Know About Withdrawing Money From a Traditional IRA]
Benefits of a Roth Conversion
The primary benefit of a Roth conversion is to reduce the account owner’s tax bill.
“Contributions to a Roth IRA are made with after-tax dollars. This means you don’t get an income tax deduction upfront like you would with a traditional retirement account,” said Doug Carey, a chartered financial analyst and president of retirement planning software company WealthTrace in Zionsville, Indiana, in an email.
However, he added, withdrawals from a Roth IRA in retirement are tax-free as long as the account owner is 59 1/2 or older and the account has been open for at least five years.
Carey cited other benefits of a Roth conversion, such as the lack of required minimum distributions. That differs from a traditional IRA, which is funded before taxes. When the owner of a traditional IRA reaches age 73, they are required to take a distribution and pay taxes. The rationale is that no taxes have been paid on the money and now the government wants its take.
However, since taxes have already been paid on a Roth IRA, there’s no urgency to make a withdrawal.
Estate planning is another advantage of a Roth IRA. “Unlike with a traditional IRA or 401(k) account, those who inherit a Roth IRA do not pay income taxes on withdrawals or distributions,” Carey said.
The Backdoor Roth
A so-called backdoor Roth strategy allows high-income taxpayers to contribute to a Roth IRA despite income limits.
It involves making a nondeductible contribution to a traditional IRA and then converting that amount to a Roth IRA. This process gives high earners a workaround to the income restrictions that prevent direct contributions to a Roth.
During the conversion, taxes are paid on any earnings in the traditional IRA, but future growth and withdrawals from the Roth IRA are tax-free, provided certain conditions are met. This strategy is beneficial for those seeking tax-free income in retirement.
“One thing to note is that by doing this you won’t get the deductibility on income for your traditional IRA contribution that you may get normally if you hadn’t converted the funds to your Roth IRA,” Garcia Cisneros said.
[See: How to Reduce Your Tax Bill by Saving for Retirement.]
Pitfalls to Avoid
Retirement savers considering a Roth conversion should be aware of the tax consequences. Because you’ll be taxed on the amount you convert to a Roth, you may find yourself in a higher tax bracket.
“Too many people convert to a Roth IRA when their income tax rates are high,” Carey said. “This rarely makes sense. It is important to convert when your income tax rates are at their lowest, which is usually after retiring and before pension and Social Security payments begin.”
In addition, Carey said, investors mulling a Roth conversion should figure out where the taxes will come from. ” If you have to pay the taxes out of the account being converted, it makes the conversion much less valuable since that money will not be converted to the Roth,” he said.
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How to Convert to a Roth IRA originally appeared on usnews.com
Update 07/19/24: This story was published at an earlier date and has been updated with new information.
