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Roth Conversion Strategy

By August 14, 2017 No Comments

Roth? . . Roth conversion? . . Roth conversion strategy? . .
Do some of these terms sound almost foreign to you? If you’re not familiar with IRAs, the Roth account or its benefits specifically, your head might already be spinning.

And you’re certainly not alone.

To start, the Roth is one of two types of individual retirement accounts (IRA) – the other type being the traditional IRA. Unfortunately, many Americans don’t understand the importance of an IRA (and even fewer understand the importance of the Roth IRA). Naturally, this is reflected in the number of people who make contributions to IRAs.

In fact, the overwhelming majority of Americans aren’t making regular contributions to IRAs.

But those who do? Well, they have a significant advantage. Those who are utilizing a Roth IRA, specifically? Often these people have an even greater advantage, and they save a lot of money while also reducing their overall tax burden when they reach retirement. That sounds pretty good, no?

So what is stopping people from opening IRAs or converting traditional IRAs to Roth IRAs when it becomes beneficial? Here are a few of the most common scenarios:

  • Many have simply thrown all of their eggs into the 401(k) basket. As long as I’m setting money aside, I should be fine . . . right?
  • Many don’t have a good grasp on how Roth IRAs or traditional IRAs work, let alone the conversion element – and frankly, many just don’t care enough to learn about them. Perhaps the information seems overwhelming, or perhaps putting it off is easier than trying to figure it out.
  • Many aren’t seeking financial advise from a professional. Navigating your finances by yourself can be done – but in that case, you had better do your homework! Working directly with a trusted financial advisor is usually a much safer choice.

If you identify with any of these, you’re in the same boat as countless others. But you can change that with a little knowledge and a few adjustments.

Now, let’s get out of that boat.

Roth: Why All the Hype?


If you know me, you know that I really value Roth conversion strategy. The concept of Roth conversion is severely underrated – not only because the benefits of Roth IRAs are great to begin with, but also because those benefits have actually improved in a number of ways, over time.

And the “conversion” element? It’s exactly what it sounds like – the transferring of a balance from one account to a Roth account.

In case you are new to IRAs, let’s compare the traditional IRA and the Roth IRA, what has changed, and then we’ll take a look at how conversion actually works.

IRAs: Traditional vs. Roth


Both account types have their own set of benefits, but let’s start with what is perhaps the biggest difference between a traditional IRA and a Roth IRA – the time at which each account is taxed. A traditional IRA is taxed in the year(s) in which withdrawals are made, whereas Roth IRA contributions are taxed up front.

Why is that so important?

First, consider your current tax bracket, and then your projected tax bracket. If you fall into a lower tax bracket today but foresee falling into a higher tax bracket in the future, that information should have a significant effect on which account(s) you choose to utilize.

Of course, there’s an element of uncertainty to all of this. Accurately forecasting future tax rates and the tax bracket you’ll fall into 20 years down the road is a pretty tall order . . . If you are unable to predict where you’ll be in 20 years, there are 2 choices that are safer than others: diversify or Roth .

If you choose to diversify and have money in both IRA types, one account’s disadvantage will be the other’s advantage. In other words, say you happen to fall into a lower tax bracket later in life – if your Roth IRA is more unfavorable, you will likely be reaping the benefits of a traditional IRA. And vice versa – say you fall into a higher tax bracket later in life – if your traditional IRA is more unfavorable, you will likely be reaping the benefits of a Roth IRA.

If you choose a Roth IRA, at least you will not have the burden of paying taxes on withdrawals later in life. You will have paid tax on those contributions up front; and you will enjoy tax-free growth and withdrawals on that account during retirement, regardless of your tax bracket. You may have dodged a bullet.

Imagine for a moment that you chose to only make contributions to a traditional IRA.

First, you are agreeing to pay taxes when the time comes to withdraw funds. Because so many retirement savings accounts are already tax-deferred, a traditional IRA only adds to the amount of tax that is due when you start making withdrawals in retirement. This could prove to be a burden to you at a time when you are no longer working.

Second, what could add insult to injury is if you fall into a higher tax bracket during retirement. That tax burden is only accentuated by the fact that you may have saved money by paying taxes up front – when you were in a lower bracket, and when you may not have needed the “early” tax break of a traditional IRA.

I Have a Traditional IRA. Is Roth Conversion Right for Me?


If you already have a traditional IRA, you may want to consider Roth conversion. I mentioned earlier that timing, as well as your current and projected tax brackets play a huge role in determining whether Roth conversion is ideal for you. But additionally, there are a number of benefits to Roth that you should strongly consider:

  1. Real Tax-Free Growth

The reason why IRAs appeal to so many in the first place is the tax-free growth incentive. However, this incentive clearly favors one IRA over the other.

With a traditional IRA, yes, your money will grow; but remember, you still haven’t paid taxes on those contributions. That comes at the time of withdrawal. So rather than paying taxes on your contributions only, you are required to pay taxes on whatever you withdraw – and as you empty that account, this inevitably includes the growth that has accumulated. What’s worse is that everything is taxed as ordinary income. So any interest, capital gains, and dividends are taxed at the current income tax rate – the latter often being much higher than that of the former.

With a Roth IRA, however, you pay all of your taxes up front. This means that when you withdraw funds down the road, the growth that has accumulated over time goes untouched as well.

  1. No Required Minimum Distributions (RMDs)

With a traditional IRA, you are required to take RMDs once you reach the year that you turn 70½. This is a real bummer if you have plans to retire at a later age, or if you wish to keep that account for an heir after you die.

With a Roth IRA, there are no RMDs – at least not during your lifetime. If you want to wait until age 90 to start withdrawing funds from your Roth, so be it. If you don’t want to make any withdrawals during your lifetime, you can even do that.

  1. No Age Restrictions

A traditional IRA allows you to make contributions until the age of 70½, which is also the age when you are required to start taking RMDs.

A Roth IRA has no age restrictions, so you are able to continue making contributions for as long as you wish. This is particularly beneficial if you are not yet ready to retire once you reach 70½, or if you’d like to see more growth on your account for a longer period of time.

  1. A Tax-Exempt Account

For estate planning purposes, a Roth IRA is the perfect inheritance to leave for a loved one. While RMDs come into play when the Roth account is passed on, there is still no tax that is required on the account balance. Your loved one can make withdrawals without any tax burden to worry about.

Converting to Roth: Things You Need to Know


Sounds great so far, right?

Even with all of the additional benefits that Roth conversion provides, you should still cross your t’s and dot your i’s to be sure that the good outweighs the bad in your circumstance.

The good news is that after 2010, Roth conversion became a whole lot easier. While there are still restrictions and disadvantages that may apply (depending on the scenario), access to Roth via conversion is better than ever.

First, let’s start with what you must know before converting from a traditional IRA to a Roth IRA.

There are 3 ways to achieve traditional IRA to Roth IRA conversion:

  1. A rollover – Once you receive a distribution, you roll it over to your Roth IRA within 60 days.
  2. Trustee-to-trustee transfer – You direct the trustee of your traditional IRA to transfer an amount to the trustee of your Roth IRA.
  3. Same trustee transfer – If you have the same trustee for both your traditional IRA and Roth IRA, you can direct that trustee to transfer an amount from one account to the other.

Now, a few elements come into play upon conversion. The first is this: when you withdraw funds from your traditional IRA, you are required to pay taxes on that amount, at the current tax rate for your current tax bracket. In essence, you have deferred on taxation to that point in time, and the amount then becomes an after-tax contribution to your Roth IRA. You won’t have to pay taxes on that amount again.

In order to really capitalize on the benefits of Roth conversion, you should consider converting in consecutive years, rather than a one-time conversion. This should be discussed with your financial advisor and controlled carefully, as you can easily push yourself into a higher tax bracket by not managing your conversions properly. The goal should be to maximize the amount of money you convert to Roth, without exceeding that threshold that pushes you into the next tax bracket. Your conversion can be as aggressive or gradual as is advantageous to you.

The tax that is due upon conversion – where should it come from, exactly? This question doesn’t necessarily have a wrong answer, but it definitely has a best answer. If you’ve been following my blog for a while, you may remember the post where we talked about the 3 “buckets” – tax-deferred (TDA), after-tax, and taxable accounts. Well, of course, the tax could be paid from a traditional IRA (tax-deferred), but you wouldn’t reap the full benefit of conversion. It’s actually most beneficial to pay tax with funds from a taxable account. Again, this is why tax diversification is so important and why you should take full advantage of the 3-bucket system.

Another factor to note is that required minimum distributions (RMDs) can’t be rolled over or transferred. So if you are taking RMDs and you convert that money to your Roth account, you are likely to get in trouble with the IRS and incur penalties.

On the subject of penalties, it’s important to note that there are early-withdrawal penalties associated with both IRA account types. Typically, no withdrawals can be made without penalty until the age of 59½ – but exceptions have been made for Roth conversions. However, if you were to then make a nonqualified withdrawal from your Roth IRA within 5 years of conversion, that withdrawal may then be subjected to the old penalty.

The next thing to note is that income and filing status requirements for conversion have been completely eliminated. Previously, your modified adjusted gross income (MAGI) couldn’t exceed $100,000. That is no longer the case. Additionally, your filing status couldn’t be married filing separately. That is also no longer the case.

When you convert to Roth, however, you do incur an income limit that affects the amount you are able to contribute annually – an income limit that doesn’t exist with a traditional IRA. Typically, for both the traditional IRA and the Roth, your annual contribution can be up to $5,500 and $6,500 once you reach the age of 50. But in order to maximize what you are allowed to contribute, you’ll want to make sure that your MAGI falls within the following specified ranges before switching to Roth. As of 2017, here are the most current figures:

  • If your filing status is single or head of household, your maximum annual contribution is reduced if your MAGI is greater than $118,000; and anything greater than $133,000 makes you ineligible to contribute.
  • If your filing status is married filing jointly or widow(er), your maximum annual contribution is reduced if your MAGI is greater than $186,000; and anything greater than $196,000 makes you ineligible to contribute.
  • If your filing status is married filing separately, your maximum annual contribution is reduced if your MAGI is greater than $0; and anything greater than $10,000 makes you ineligible to contribute.

Many employer plans, like traditional IRAs, are tax-deferred accounts; and as you’d expect, most of the same rules apply, which makes most tax-deferred conversions to Roth relatively similar. But before you roll over funds from an employer plan, such as a 401(k) plan, to a Roth account, you should be asking your employer whether the distribution is even eligible to be rolled over. Once confirmed, the conversion works much like it would with traditional IRA.

Today, more and more people are excited by what Roth conversion offers, as the benefits often outweigh that of tax-deferred accounts in many different circumstances. Roth accounts may benefit your portfolio in a significant way – whether today or 40 years from now, depending on your current situation and your goals for the future. If you haven’t already, I strongly recommend that you have a conversation with your financial advisor on the subject. Your future self may thank you.

If you have any further questions regarding Roth accounts, Roth conversion, or anything else, feel free to get in touch with me! I’m more than happy to assist you in any way that I can.

Humphrey G. Thomas is registered with and offers securities through Kovack Securities, Inc., member FINRA, SIPC. 6451 N. Federal Highway, Ste 1201, Fort Lauderdale, FL 33308 (954) 782-4771 Advisory services offered through Kovack Advisors, Inc. HG THOMAS WEALTH MANAGEMENT, LLC and Empower Your Wealth unaffiliated with Kovack Securities, Inc. and Kovack Advisors, Inc. Humphrey G. Thomas is registered in GA,MN and TX. Check the background of this financial professional on FINRA's BrokerCheck