What are the Pros and Cons of a Roth IRA Conversion?

There are several kinds of retirement savings accounts that you can invest in based on your risk profile, investment horizon, and future goals. The most popular retirement accounts among these are the 401(k) and the Individual Retirement Account (IRA). These accounts have served the needs of many retirees enabling them to save for their future retirement expenses. Simply put, a 401(k) is a company-sponsored retirement plan that the employer offers to the employee whereas an IRA is a tax-advantaged retirement savings account that can be opened at the bank, with a broker or union.

There are several kinds of IRAs available to choose from including traditional IRA, Roth IRA, SEP-IRA, and SIMPLE IRA. Each IRA serves a unique purpose. Take the traditional IRA for instance. If you pick this retirement plan, you contribute pre-tax dollars and do not pay any taxes on your earnings until your retirement. However, you will have to pay tax on your withdrawals as per your taxable income for the concerned financial year. For a Roth IRA, you contribute after-tax dollars, and similar to a traditional IRA, you do not have to pay any taxes on your earnings until your retirement. But you can make tax-free withdrawals in retirement provided you are 59.5 years of age and have held your Roth account for a period of five years. Coming to SEP-IRA, this retirement account is primarily used by small businesses or self-employed individuals. It adheres to the same tax rules that a traditional IRA does. Additionally, SIMPLE IRA or Savings Incentive Match Plan for Employees also caters to small businesses and self-employed individuals. It follows the same tax rules for withdrawals as a traditional IRA and allows employees to make contributions to their accounts. If you wish to learn about different types of retirement plans along with their pros and cons, reach out to a professional financial advisor who can guide you on the same.

If you pick a traditional IRA, you have the option of rolling over your account into a Roth IRA. Roth in-plan conversions happen quite often.

In this article, we will discuss what you need to know when considering a Roth IRA conversion.

What is meant by a Roth IRA rollover? 

A Roth IRA rollover or conversion means the transfer of cash and other assets from one retirement plan to another i.e. from a traditional IRA, SEP-IRA, SIMPLE IRA, or a 401(k) to a Roth IRA. You should keep note of the following things when converting a traditional 401(k) or IRA into a Roth account:

• At the time of conversion, you will have to pay income tax on the funds you convert. This occurs due to the fact that you make tax-deductible contributions in traditional IRA accounts but must contribute after-tax dollars in a Roth account. Hence, you need to cover the difference in taxes that you owe upon conversion. These taxes must be paid in the same year the conversion takes place. Doing so would likely place you in a higher tax bracket for the concerned year.
• When going for a Roth in-plan conversion, you can either opt for a complete or partial conversion. If you decide to convert the entire value of your account, you would owe taxes on the entire account's value. You can lower your tax burden by opting for partial conversions. This would ensure you do not fall into a higher tax bracket for your overall income for the year. It is advised that you consider a partial rollover especially if you have a high corpus amount in your traditional retirement account.
• To figure out how much you would owe in taxes, you must file Form 8606 at the time of converting your account. You can also take the help of a Roth IRA conversion calculator. It offers precise and error-free results based on which you can determine whether to go for partial or complete conversion.

As stated above, there is a five-year rule that you must adhere to when opening a Roth account. As per this rule, you cannot make any drawings from a converted Roth IRA for up to five years after the conversion. If you end up making a withdrawal in the first five years, you will have to pay a 10% penalty on the amount withdrawn. In the case of partial conversions, the rule is applied to every conversion meaning each of the partial conversions will be penalized separately. For example, say you converted $2,000 in 2021 and $3000 in 2022, you would not be able to withdraw the $2,000 until the year 2026 and $3000 until 2027. However, if you do make a withdrawal, you will have to pay a 10% penalty on each individual conversion to the Internal Revenue Service (IRS). Thus, do make a note of all your partial conversions if you wish to avoid paying the penalty. 

The five-year rule comes into effect on the 1st of January of the year of the conversion. Further, the penalty is only charged on the earnings made by you and not your contributions.

What are the different pros and cons of a Roth IRA? 

Benefits of a Roth IRA rollover:

There are several advantages of a Roth in-plan conversion. These include:

1. Can make tax-free withdrawals:

Arguably, the most attractive aspect of a Roth IRA retirement plan is the ability to make tax-free withdrawals. Though you do not get an immediate tax break with a Roth IRA, however, you can reduce your taxes in retirement. A Roth conversion is especially helpful if you expect to be in a higher tax bracket in retirement. If you have owned your Roth account for five years and are 59.5 years of age or older, your withdrawals will not be taxed or added to your taxable income.

2. Can make withdrawals for certain exceptions:

You can break the five-year rule of a Roth IRA account in certain cases. These are:

• • First-time homebuyers can withdraw up to $10,000 for making the down payment on their first house.
  • If you want to pay for higher education expenses for yourself, your spouse, children, or grandchildren, you can withdraw up to $10,000 for the same.
  • You can withdraw money to pay for health insurance premiums. You won't be charged a penalty on the same.
  • If you are unemployed, you can withdraw money from your Roth IRA to meet your living expenses.
  • You can also make a penalty-free withdrawal in case your medical expenses add up to more than 10% of your Adjusted Gross Income (AGI).

3. Don't have to pay Required Minimum Distributions (RMDs):

Roth IRAs do not have mandatory RMDs unlike traditional 401(k)s and IRAs. This means that you are not mandated to withdraw your Roth IRA funds when you reach 72 years of age. A Roth IRA offers great flexibility wherein you have the power to either withdraw your money should you choose to or let it sit in your account as per your needs. 

4. Can save taxes:

If you are not careful, you may end up paying higher taxes in retirement than you did in your working years. Your retirement income can include the following:

• • your life's savings
  • capital gains from stocks
  • dividends from bonds
  • insurance payouts
  • Social Security benefits

If you opt for a Roth conversion, you can avoid paying taxes on your traditional IRA or 401(k) in retirement. Suppose you have a considerable amount of savings and investments, you may very well fall into a higher tax bracket in the future. Make a list of your expenses in retirement and accordingly plan for a Roth IRA rollover. Not having to pay RMDs as well as the ability to make tax-free withdrawals may lead to a more financially comfortable life. Further, paying taxes in the present may be a more financially prudent decision as you will be paying them on your income. In addition, if you wait till retirement to redeem your investments and realize your capital gains, you may lower your tax liability too.

5. Can diversify your investments:

Many people believe that diversification is limited to the kind of assets you invest in, their returns, and the associated risks. However, you must be heedful of tax diversification as well. If you have all your money invested in traditional retirement savings accounts, you may consider shifting some of those funds to a Roth account. For example, if you own a traditional IRA and 401(k) account, you may consider going for a Roth IRA rollover. Doing so will not only allow you to diversify your taxes but also enable you to take advantage of the exceptions mentioned above. This can prove immensely beneficial in case of any financial emergencies that you may experience in the future.

6. Can be more beneficial for your beneficiaries:

The IRS mandates that non-spouse beneficiaries, such as children or grandchildren, must withdraw the entire account's value within a period of ten years of inheriting it. The important thing to note here is that the beneficiaries are not obligated to pay any tax on the withdrawn amount. This means that you can leave your heir or beneficiaries the entire value of the account and secure their financial future.

SPONSORED WISERADVISOR

Drawbacks of a Roth IRA Rollover:

Despite the many benefits of Roth IRA, a Roth IRA may not be suitable for you due to the following reasons:

1. Your tax liability may increase in the present:

Having a Roth IRA account increases your tax burden in the present. This is further amplified if you are in a high tax bracket now. A Roth conversion is particularly helpful if you foresee yourself being in a higher tax bracket in the future and reducing your taxes in retirement. If you do not expect that, you would be better off going with a traditional retirement account.

2. You may have to defer achieving other goals:

Having a higher tax rate in the present may result in deferment of your other goals. There are a lot of things to take care of during your pre-retirement years. From having to pay off debt like student loans, home loans, etc. to saving for your children’s college tuition, tackling financial emergencies, travel, and saving for retirement. If you shift your entire focus on achieving one goal such as saving for retirement, it may lead to compromising on attaining other goals. A higher tax rate at the present may also lead you to lower your investment and savings rate while having to reduce your expenses at the same time. Further, it may play spoilsport with your emergency fund and put the brakes on your financial progress in general. This may lead you to become stressed and lose your peace of mind.

3. Your Medicare premium may cost you more:

Your Modified Adjusted Gross Income (MAGI) plays an important role in determining your monthly premium for Medicare Part B and Part D. To calculate your monthly Medicare premium, your MAGI for the last two years before enrollment is considered. For example, if you signed up for Medicare Part B and Part D in 2021, your MAGI for 2020 and 2019 will be considered to determine your monthly premium. This means that your initial Medicare premiums may cost you more if you choose to go for a Roth in-plan conversion. The good thing is that the premium is decided every year and may decrease with a decline in your annual taxable income.

4. You may lose protection against creditors:

Compared to IRAs, 401(k) accounts are afforded better protection against creditors. Though the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 does provide federal bankruptcy protection to traditional and Roth IRAs, as of April 2022, it limits the protection to a sum of $1,512,350 per person. These limits are revised every three years and adjusted for inflation. They are applicable to all kinds of IRAs, including rollovers. However, if you have a high corpus value and are concerned that you will be targeted by creditors, you may not entirely be in the clear with respect to creditors. You may get a favorable ruling in bankruptcy courts and receive protection to higher values if the courts find it fair, but keep in mind that there is no law that governs this. Hence, there is always a likelihood of losing your money.

5. Your Social Security benefits may be taxed:

If you have already begun claiming Social Security benefits, if you opt for a Roth IRA conversion, your taxable income for the year will increase and you would have to shell out tax on your contributions made so far as well. Doing so would not only place you in a higher tax bracket but also increase your Social Security tax rate. 

What are some Roth conversion strategies for retirees age 65 and above?

If you are thinking about converting your 401(k) or traditional IRA into a Roth IRA at the age of 65, you may either be retired or fast approaching retirement. There is no age limit for undertaking a Roth conversion. You can go for a Roth conversion at any age and stage of your life. Did you know that most retirees give serious consideration to a rollover in their early years of retirement?

If you are one of such people, you need to take a long, hard look at your income. The most beneficial time to go for a Roth conversion is when you are earning a relatively low income. Doing so would not only keep your taxes at a minimum but also allow you to receive a larger benefit during your retirement years.

That said, you need to consider the expenses that occur when you roll over your account. It may take a while before you can benefit from the ensuing tax break. Firstly, the year you carry out the conversion, your tax liability will increase that year due to having to pay taxes on the funds converted by you. You can take the help of a Roth IRA conversion tax calculator here that will allow you to compute your current tax rate to make an informed decision.

To conclude

Understanding the various benefits and drawbacks of Roth IRAs will allow you to figure out what happens when you go for a Roth conversion. Most folks tend to focus on the visible tax breaks that they will receive while ignoring the impact of the rollover on other aspects such as your retirement accounts, Social Security benefits, additional goals, age, Medicare, and more. If you neglect to factor in the impact of the conversion on the aforesaid aspects, you may find it more challenging to attain your goals. So, do try and consider the different pros and cons in detail before making your decision.

If you want to understand the impact of a Roth IRA conversion on your taxability, withdrawals, and more, use the free advisor match service to connect with 1-3 financial advisors based on your financial requirements. All you need to do is answer a few simple questions about yourself and the match tool will find advisors that match your financial needs.