By David Munn, CFP
Have you ever wondered if there's a way to reduce your annual income tax bill in retirement? A Roth conversion might be the answer. It's a strategy that involves moving money from a 401(k) or Traditional IRA (where contributions are typically pre-tax) to a Roth IRA (funded with after-tax dollars). The key benefit? Tax-free growth and withdrawals in retirement.
Understanding the Tax Trade-Off
There's a catch, of course. You'll likely owe income tax on the converted amount in the year of the conversion. So it's like paying taxes upfront in exchange for tax-free benefits later. This might seem counterintuitive, but it may be a smart move depending on your situation.
Why a Roth Conversion Could Be Right for You
Here are some scenarios where a Roth conversion might be advantageous:
Lower Tax Bracket Now, Higher Later: Think you'll be in a higher tax bracket through your retirement years? Locking in today's potentially lower rate by paying taxes now on the conversion can save you money in the long run. This is especially true for young earners who expect their income (and tax bracket) to rise in the future, but could also apply to those who are temporarily unemployed or recently retired.
Maximizing Heirs' Benefits: Roth IRAs don't have Required Minimum Distributions (RMDs) – mandatory withdrawals that begin at age 73. This means your money can continue to grow tax-free and potentially leave a larger inheritance for your heirs. They'll also enjoy tax-free withdrawals if they follow IRS distribution rules.
Tax Diversification: Most retirement savings are in pre-tax accounts. A Roth conversion can diversify your holdings by adding a tax-free bucket, potentially lowering your overall tax burden in retirement, especially in years with higher expenses like vehicle purchases, expensive vacations, or home projects.
Things to Consider Before You Convert
While Roth conversions offer potential benefits, they're not a one-size-fits-all solution. Here's what to weigh before diving in:
Your Current Tax Bracket: If you're already in a high tax bracket, the upfront tax hit of a conversion might outweigh the long-term benefits. Depending on your age and situation, you may also need to consider the impact on Medicare premiums, FAFSA benefits, taxation of Social Security benefits, health insurance subsidies, etc.
Retirement Income Needs: The amount of retirement income you will need to draw from savings, the role Qualified Charitable Distributions, and potential medical or long-term care costs might play in your retirement plan may impact the benefits of a Roth Conversion, as there may be alternative strategies to avoid paying taxes on IRA distributions.
Short-Term Needs: The money used for the conversion tax bill needs to come from outside your retirement savings if you are under age 59.5. Make sure you won't need those funds for short-term goals.
Consulting an Advisor
A Roth conversion can be a complex financial decision. It's wise to consult with a financial advisor to determine if it aligns with your overall retirement strategy. They can help you assess your tax bracket situation, project future income, and ensure the conversion makes sense for your unique financial picture.
This material is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product or concept for any particular advisor or client. This material is not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisors. Munn Wealth Management, LLC, is registered as an investment adviser (RIA) with the United States Securities and Exchange Commission. Registration as an investment adviser does not imply any certain degree of skill or training. 1323GQZ