Examining the Roth Conversion Option
A mountaineer’s decision of whether to trek in snowshoes or crampons involves numerous factors. How deep is the snow, and is the trail beneath it packed? Is the snow crusted on top, and if so, how much weight can it support? How hard is it snowing, and how fast is the fresh snow firming? Is the terrain too steep for snowshoes, and can you safely swap traction? At first glance, choosing between a Traditional and Roth Conversion IRA seems straight forward, but proper due diligence reveals that, like with the climber’s selection of traction, the implications are a bit more complex than they first appear.
The basics
Traditional IRA contributions are tax-deductible, earnings grow tax-deferred, and withdrawals are fully taxable as income. Withdrawals are penalized 10% if taken before age 59½, and required minimum distributions (RMD’s) begin at age 73 (increasing to age 75 in 2033).
Funds converted from a Traditional IRA to a Roth IRA are taxed as income in the year of conversion, earnings grow tax-deferred, and withdrawals are tax free (when the rules are obeyed). Roth Conversions have no RMD’s, but earnings withdrawn prior to age 59½ are taxed and penalized, and each conversion requires a five-year holding period (to avoid a 10% penalty) and must be tracked.
The macro question is, will you benefit more by deducting contributions to retirement accounts (Traditional), or by avoiding taxes on retirement account earnings (Roth)? While advanced financial planning software can quickly find the apparent answer, even keeping ‘all other factors’ constant, there are additional factors.
The ‘not so’ basic
By reducing taxable IRA withdrawals, a Roth Conversion can keep you in a lower tax bracket in retirement and reduce the taxability of Social Security benefits. Additionally, beneficiaries will pay income taxes on Inherited Traditional IRA withdrawals, but not on Inherited Roth Conversion withdrawals (provided the five-year rule is met), enhancing the multi-generational aspect of your wealth-building.
Conversely, for those already receiving Social Security and Medicare benefits, a Roth Conversion will increase taxable income, which can raise both Social Security taxes and Medicare premiums. The Roth Conversion can also be problematic for those already receiving taxable distributions from Traditional IRA’s, and for those without sufficient non-retirement savings to pay the Roth Conversion tax due. It is inadvisable to have the Roth Conversion tax taken from the IRA itself, especially for those under age 59½, as the amount withheld will involve an early distribution 10% penalty. ¹
The strategic approach
Capitalize on strategic Roth Conversions and help minimize the taxation of your total retirement savings without increasing Social Security taxes or Medicare premiums by having your investment adviser work through the Roth Conversion option with your tax preparer annually. Never miss a highly beneficial Roth Conversion opportunity to neglect!
On two occasions, I have been endangered in the mountains by the wrong choice of traction. How you navigate the tax terrain with your retirement accounts is as financially consequential. God bless your planning efforts!
Shaun.
“Render to Caesar the things that are Caesar’s, and to God the things that are God’s.” ~Matthew 22:21
1 Smart Asset, “Ask an Advisor: Help Me Understand the ‘Best Way’ to Manage an IRA. Is It Better to Pay Taxes Now or in Retirement?”, by Michelle Cagan, CPA, February 2, 2024
The opinions voiced in this article are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which strategies or investments may be suitable for you, consult the appropriate qualified professional prior to making a decision.
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