Roth Conversion: A Better Way to IRA

Roth IRAs are known for their tax-free growth and withdrawals; however, high earners and retirees regularly overlook these dream savings accounts because they have income limits that, on the surface, prevent them from participating. At Stratos Private Wealth (SPW), we think that Roth conversions are an effective, alternative way to save money in a Roth IRA, not subject to IRS limits. With the right planning and a little foresight, Roth conversions can help people maximize their retirement savings and save money on taxes.

What is the difference between a Roth IRA and a Traditional IRA?

Roth IRA money is taxed on the way in; the money then grows tax-free and is withdrawn tax-free in retirement. Conversely, traditional IRA money is taxed on the way out. Investors make pretax contributions, the money grows tax deferred, and taxes are paid when the money is withdrawn.

A key differentiator between Roth IRAs and Traditional IRAs is that Roth IRAs have income limits on contributions. In 2020, any household with an adjusted gross income (AGI) greater than $206,000—139,000 for an individual—cannot contribute directly to a Roth IRA. That said, do not write off Roth IRAs entirely if your income exceeds these limits because a Roth conversion may still be a viable option.

What is a Roth conversion?

A Roth conversion is the process of converting funds from a traditional IRA to a Roth IRA. In doing so, you are essentially opting to pay taxes up front instead of forgoing taxes until the money is withdrawn.

When should you convert to a Roth IRA?

Roth conversions allow you to reap the benefits unique to Roth IRAs, regardless of your income. Two notable benefits are (1) tax-free withdrawals and (2) the absence of required minimum distributions (RMDs), which refer to a certain amount of money investors typically must take from their traditional IRAs each year once they turn age 72:

1. Roth conversions allow you to pay taxes now instead of later – If you anticipate that your income-tax rate will be greater in future years than it is today, converting funds to Roth may save you money on taxes in the long run.  For example, take a recently retired individual who is not yet taking RMDs. It’s safe to assume that their current income-tax rate is low relative to when they were working, and relative to when RMDs begin. Therefore, it could be wise to do a Roth conversion today and pay taxes at the comparatively lower rates. Tax years are “use it or lose it,” so don’t let the low tax years goes to waste.  Other good candidates for Roth conversions are young, high-income earners who make too much money to contribute to a Roth IRA directly, but who expect to earn even more money in future years. It might make sense for them to pay taxes on converted money at their current marginal rate. They could make nondeductible contributions to a traditional IRA, and immediately convert those funds to a Roth.  Sophisticated readers will point out that if you’re unable to contribute to a Roth IRA, you probably cannot deduct traditional IRA contributions either, because those deductions also go away above similar income limits. Even without the deductibility of IRA contributions, Roth conversions can still be worth it for high earners.

   At Stratos Private Wealth, we work closely with our clients and their CPAs to try and “smooth out” client marginal tax rates in retirement. One effective strategy mirrors a “Price-Is-Right” approach—try to fill up your current income-tax bracket via a Roth conversion without bumping yourself into the next bracket. SPW can help you estimate these amounts with our planning software and can work directly with your CPA to help you determine the optimal amount you should convert each year.

2. Roth can help mitigate Required Minimum Distributions – Roth IRAs are also surprisingly savvy estate-planning tools because they do not have RMDs. Aptly named, RMDs are mandatory, and they can force wealthy investors to draw down their traditional IRA assets even when they do not need the money. If your income demand in retirement is less than your RMD, a Roth conversion could help you avoid any unwise withdrawals.  When converting funds to a Roth, it is important to carefully consider the tax implications and discuss the strategy with your tax advisor ahead of time. Ideally, you are looking to balance the taxes paid today as a result of the conversion versus your long-term tax savings down the line.