Converting to a Roth IRA

The Smartest Tax Move You Can Make in 2020

The Roth IRA may just be the very best retirement savings vehicle currently available to the American investor, whether you are young or old, white collar or working class. This type of account is a fantastic means by which to invest savings for retirement, and the special features, most notably tax-free withdrawals and the lack of compulsory distributions, give the Roth IRA a huge leg up on traditional IRAs and other types of retirement savings accounts. With the passage of the SECURE Act last year lengthening the window for people to build retirement savings, this is an opportune time to see how Roth and traditional IRAs stack up and how you can take advantage of them.

IRA Basics

There are two main types of IRAs: Traditional and Roth, both of which have the same annual contribution limits (for tax-year 2020, the limit is $6,000; $7,000 for those over 50). With a traditional IRA, contributions are tax-deferred and may entitle you to a tax deduction; all gains compound tax-free until you make withdrawals, at which point you will be subject to income taxes on what you take out. (You will also be assessed a 10% penalty on any withdrawals made before age 59½.) With a Roth IRA, contributions are made from after-tax income, but any investment gains you make are not taxed, and no tax is owed when money is withdrawn.

Required Minimum Distributions

One catch with a traditional IRA is required minimum distributions (RMDs). Once you hit age 72, you are obligated to withdraw a certain amount of your IRA’s assets each year or face penalties. RMDs are mandated by the IRS, which provides several tables—the most common being the “Uniform Lifetime Table”—to help taxpayers calculate what they need to withdraw each tax year. For tax-year 2019, for example, an 80-year-old retiree with a $100,000 IRA was given a “distribution period” of 18.7 years to fully draw down her IRA. So to calculate her distribution, she would have divided her account value by 18.7 to come up with her RMD of $5,348.

There are no RMDs for Roth IRAs; you can continue to grow your account for as long as you want. For this reason, Roth IRAs are a good way to save money tax-free to leave to your heirs. Otherwise, like a traditional IRA, you are subject to that 10% penalty on withdrawals of any gains or income before age 59½ (or if you violate the five-year seasoning rule). After that, all distributions are tax-free.

Contributions

Traditional IRAs are also less friendly to investors over certain income thresholds who are also covered by an employer-sponsored retirement plan. In tax-year 2019, if you contribute to say, a 401(k) plan and make more than $122,000 as a single tax filer (or a combined $193,000 for married couples filing jointly) your tax deduction for contributions to an IRA begins to be limited—if you make more than $137,000 ($196,000 for married couples), your contribution becomes nondeductible.

That doesn’t mean you can’t contribute to an IRA. In fact, many people do. You just can’t deduct your contributions when you make them (though you will be able to deduct those after-tax contributions from further taxation when you make withdrawals down the road).

The Roth IRA is a different animal. All contributions are made after-tax, and those contributions can be withdrawn tax-free at any point. If you add $3,000 to a Roth in one year and find you need to spend that $3,000 the next year, you can withdraw it without taxes or penalties.

Rollovers and conversions can be withdrawn tax- and penalty-free after a five-year “seasoning” period regardless of your age, and there are a number of special circumstances (such as severe disability, high medical expenses or a first-time home purchase) in which distributions can be taken penalty-free.

The rub, however, has always been the Roth’s limited accessibility. Investors who make over $122,000 a year as a single tax filer (or married couples, filing jointly, with a combined income over $193,000) are limited in how much they can contribute to a Roth IRA. If you make over $137,000 a year as a single tax filer ($203,000 for those married, filing jointly), you can’t contribute to a Roth IRA at all (these income limits are for tax-year 2019 and increase from year to year, based on inflation).

Traditional vs. Roth: Pros and Cons

So, the basic advantages and disadvantages of these two types of investments are pretty clear-cut:

Traditional IRAs

• Give you an immediate tax deferral when you contribute
• Allow tax-free compounding until it’s time to begin taking withdrawals
• Require you to pay income tax when you make withdrawals
• Penalize you for any withdrawals made before age 59½
• Eventually require you to begin taking money out, whether you want to or not

Roth IRAs

• Give no initial tax benefit
• Offer penalty-free access to your savings
• Allow you to withdraw funds tax-free (so long as they don’t violate the five-year seasoning rule)
• Don’t require you to take withdrawals unless you want to

All together, these factors make Roth IRAs a particularly potent way to save money for retirement—far superior to a traditional IRA for many investors. The table below shows the results of taking the same $5,000 per year and investing it in the S&P 500 index over the last 30 years via both types of IRA. We’ve calculated the taxes one would pay in the 24% bracket (the highest bracket still eligible to invest in a Roth IRA) using the effective tax rate of 19.2% that a single taxpayer making $122,000 a year would be subject to.

Since contributions to a Roth IRA are made after-tax, to get that $5,000 after-tax investment, you would have to earn $6,190 pretax, and thus pay $1,190 in taxes—over 30 years, that adds up to a total of $35,701 in taxes paid on contributions. In contrast, a traditional IRA investor would have saved $28,838 in taxes on their pretax contributions to their account ($961 a year).

When it comes time to withdraw, however, the traditional IRA investor would owe over $161,000 in taxes. Even including the entire $28,838  saved on taxes when contributing, that would leave the traditional IRA investor $706,367 to spend in retirement. The Roth investor would get the entire $838,786 tax-free, and would have paid about $97,000 less in taxes while saving it.

So long as you are making steady contributions and you’ll be in the same or a higher tax bracket in retirement, a Roth IRA will net you more savings for retirement and many fewer tax headaches than a traditional IRA along the way.

Converting and Taxes

When making the conversion from a traditional IRA to a Roth IRA, the first thing you need to think about is taxes.

With traditional IRAs, taxes are generally paid when money comes out. With Roth IRAs, taxes are paid before money goes in. Conversion, in effect, takes all the money out of the traditional IRA and puts it into a Roth—resulting in a hefty tax bill in many cases.

As with most things when it comes to taxes, it’s not quite that simple. Many investors find themselves making nondeductible contributions to traditional IRAs because their annual salary and participation in an employer-sponsored retirement plan disqualifies them from taking part or all of the tax deduction.

If all the contributions you’ve made to your traditional IRA were tax-deductible, then you must pay the taxes due on the full sum of those contributions in the year when you convert—plus the taxes on any gains you’ve made while the funds were invested.

If your contributions were nondeductible, you will only have to pay taxes on any gains earned over and above your after-tax contributions.

And if you have a traditional IRA to which you’ve made both deductible and nondeductible contributions, you’ll be taxed on any gains plus the deductible contributions.

If you have more than one traditional IRA account to convert, calculations become more complex. (For example, if you established different IRA accounts while working for different employers.)

If you’re converting all your IRA accounts at once, each is taxed based on its own liability. But if you’re blanching at the thought of paying such a hefty fee to Uncle Sam in a single year, you can choose to convert only some of your accounts from traditional to Roth. In that case, however, the amount of tax you’ll owe is based on the percentage of all of the taxable funds in all of your IRA accounts that you will be converting. We recommend consulting with a tax professional if you are in this position—call us and we’ll be happy to help.

Remember, too, that you can’t count on the funds you convert into Roth IRAs being immediately available as tax-free distributions. The five-year seasoning rule applies, along with the 10% penalty for early withdrawals if you’re under 59½. If you don’t have enough cash available to pay the taxes, it may not make sense to do the conversion in the first place.

Who Should Convert?

The decision to convert traditional IRAs into Roth IRAs must be determined on a case-by-case basis. Consult a tax professional or call your portfolio team—we’ll be happy to help point you in the right direction. But in general, if you’ll be in the same or a higher tax bracket when you anticipate taking withdrawals, it might be better to pay taxes on your IRA assets in the conversion process and then not have to worry about any future taxes down the line. It could also be advantageous to make the conversion if you have a traditional IRA that you feel you won’t ever need to tap into (should you be so lucky). Converting would mean you don’t have to deal with RMDs, and instead could allow your account to grow tax-free indefinitely, perhaps to be left for your heirs.

It may not make sense to convert if you think you’ll be in a lower tax bracket when it’s time to take withdrawals, or if you’ll need to take distributions within five years of making the conversion. You should speak to a tax or retirement planning professional and carefully consider the tax implications before doing so.

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