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Roth Conversions

Retirement • Apr 24, 2024 10:15:48 PM • Lamont Brown MBA, CFP®

For many the idea of paying more taxes in retirement is overwhelming. And even worst is leaving a tax burden to those you care about.  This is a challenge that is only going to get worst if you believe taxes are going to rise in the years to come.  However, there's a potential option to reduce the impact of taxes in the long run.  Given the right circumstances and timing a Roth Conversion could be a good option for some. 

Pay Taxes Now

A Roth Conversion is simply paying taxes now to potentially reduce taxes later.  When I think of taxes and retirement accounts I remember the qoute from Rounders "Pay that Man his Money". Taxes are either paid in the year you earn the income, receive the dividend, or take the distribution.  Taxes can be deferred to a date in the future like with Individual Retirement Accounts (IRAs), and 401Ks.  Or they can be eliminated by saving after-tax money in a Roth IRA/Roth 401K.  With a Roth IRA or 401k you pay taxes now on income to pay no taxes later.  Most miss the point, you are paying taxes now for the benefit of withdrawing tax free later.  With a Roth Conversion you pay taxes now to move money from a traditional IRA/401K to a Roth account, essentially eliminating taxes later.

Potentially Reduce Taxes Later

With a Roth Conversion you reduce or eliminate two potential taxable events.  First, once you've converted assets to a Roth account you will not need to pay taxes on distributions your first contribution to a Roth was at least 5 years ago, and you are over the age of 59.5. If you meet these criteria you will not pay taxes on distributions from a Roth IRA.  Next, you will not be required to take Required Minimun Distributions (RMDs).  For all, you are required to take distributions from their pre-tax/traditional IRA accounts once you reach the mandatory year.  These lifelong distributions create a taxable event where you now have pay taxes on distribution. However, if you've converted your accounts to Roth Accounts you will not be required to make Required Minimum Distributions.

Timing is Everything

Although this seems like a perfect solution to a problem. It's not that easy.  With Roth Conversions, timing is everything.  Remember from earlier, you have to "Pay the man his Money" and pay taxes on money you are converting to a Roth account. This fact requires you pay special attention to your current tax situation, as you don't want to create a tax problem for yourself.  Further, consider the more you pay in taxes the longer it will take you to earn back what you've lost.  Also be aware of Medicare Income Related Monthly Adjustment Amount (IRMAA) surcharge when considering the best timing for a Roth Conversion.

A Roth Conversion is A Tool 

Choosing to do a Roth Conversion can be an important tool to consider as you look forward to reducing your taxes over your lifetime.  Careful consideration should be paid to timing and your ultimate goal for the funds you are converting.  Finally, pay attention to how you invest your assets after the Roth Conversion.  Consider  how long it will take to earn back what you've paid in taxes during the conversion.

There is no assurance that any investment, plan, or strategy will be successful. Investing involves risk, including the possible loss of principal. Roth conversions are complex and you cannot undo the conversion and tax impact. In order to be eligible for tax-free distributions from a Roth conversion, it must be a qualified distribution. For Roth conversions, the entire converted amount is subject to the qualified distribution rules and is independently calculated for each conversion. Any withdrawals that include the converted amount, taken within the 5 years, may be subject to a10% penalty, unless there is an existing exception to the penalty that applies. To be considered a qualified distribution, the 5-year aging requirement must be satisfied, and you must be age 59½ or older or meet one of several exemptions (disability, qualified first-time home purchase, or death among them).

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Lamont Brown MBA, CFP®

Principal Wealth Advisor