What’s a Roth IRA Conversion???

September 15, 2023

A Roth IRA conversion is the practice of taking traditional IRA funds and turning them into Roth IRA funds. Wow, that was the easiest article I’ve written. Have a great day!

OK, so yeah the above is true, but like everything else with retirement and tax planning, the devil is in the details.

The federal government has provided us with an opportunity to change our traditional IRA money into Roth IRA money. That’s an interesting idea and one most of us should consider. You can change money that will be fully taxable to you in retirement to money that is completely tax-free in retirement.

Wow… sounds like a no-brainer, right? Not so fast. Like many things that the federal government gets involved in, there is a catch. When you take money from the traditional IRA and attempt to change its status to Roth, it becomes fully taxable on the switch.

Let’s say Mary has $100,000 in her traditional IRA. Mary likes the many advantages that a Roth IRA provides so she takes a distribution of the whole $100,000 and recharacterizes it. That, according to the IRS, is a taxable event. Mary has to declare that $100,000 as income for that year and pay taxes on the whole amount. If Mary made $75,000 of taxable income from her normal job, she would declare a total of $175,000 of ordinary income for that year. Ouch. Mary could pay a hefty tax bill on that conversion.

Well, what if Mary just held out what she needed for taxes and moved the extra into the Roth? Yeah, it would be a smaller amount, but over time it would grow back and do so tax-free. Over several years of growth, it could produce an excellent income that’s tax-free in her retirement.

The problem there is that Mary is only 48 years old. If Mary were to hold out $25,000 to pay taxes, and convert the remaining $75,000 then she has taken a premature distribution from her IRA (the under

59.5 penalty). She would pay taxes and a 10% penalty on her amount withdrawn that wasn’t put back into a Roth. Her $25,000 tax holdout would cost her another $2,500 in penalties above the taxes due. Mary could have a real tax nightmare on her hands if she tried to convert her IRA.

Roth IRA conversions have the potential to be a fantastic tool. There are several strategies that can be extremely beneficial. If you and your advisor are tax-smart and use the rules to your advantage, converting traditional IRA dollars into tax-free Roth IRA dollars could be a great move for you.

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.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.