By Corey Gragg, CFP®
Wouldn’t it be nice if saving for retirement was straightforward? Instead, it may feel like anything but—especially when choosing from the many available options.
While most people know they need to invest, it can be overwhelming to sift through all the information about Traditional IRAs vs. Roth IRAs, pre-tax vs. Roth 401(k) contributions, etc. What’s more, there’s the option to move funds from a Traditional IRA (or other pre-tax retirement account) to a Roth IRA, known as a Roth IRA conversion. Talk about confusion!
When it comes to retirement planning, it’s crucial to consider the pros and cons of a Roth conversion and how those affect your personal financial plan before deciding whether to make a change. So, let’s take a deeper look into the key elements to determine whether a Roth IRA conversion is right for you.
Traditional IRA vs. Roth IRA
It’s important to note that both a Traditional IRA and a Roth IRA offer tax advantages. When you contribute to a Traditional IRA, you realize an immediate benefit by reducing your taxable income (and tax liability) in the current year. However, when you withdraw those funds from your IRA in retirement, you pay income taxes on the full amount of your withdrawals. Contributing with pre-tax dollars to a 401(k) or similar plan provided by your employer has the same tax implications.
With a Roth IRA, you’ll realize the tax benefits when you’re ready to withdraw. Since you fund your Roth account with after-tax dollars, money can be withdrawn tax-free when certain conditions are met. The biggest benefit of a Roth IRA is long-term tax-free growth.
As tempting as it is to think short term and opt for a Traditional IRA solely for the immediate tax deduction, the long-term benefits of a Roth IRA, particularly tax-free withdrawals in retirement (once you hit 59½), can prove to be even more advantageous. A Roth IRA can be a great way to mitigate taxes in your retirement years and keep more of your hard-earned money in your pocket.
So, what happens if you have already contributed to a Traditional IRA or other pre-tax retirement account, and you want to be sure this is still the best strategy for you? This is where a Roth IRA conversion may offer some very specific tax benefits.
Note: Pre-tax and Roth contributions to a 401(k), 403(b), or other employer-sponsored plan have very similar tax implications to Traditional IRAs. Similarly, Roth contributions to 401(k), 403(b) or other employer-sponsored plans are treated similarly to Roth IRA contributions.
Why a Roth IRA Conversion?
Before getting to the why, it’s important to know what a Roth Conversion is. Put simply, a Roth IRA conversion is essentially moving money from a Traditional IRA (or other pre-tax retirement account) to a Roth IRA. There are several factors to keep in mind when considering a Roth conversion. First, consider this crucial question: Would you rather pay taxes at today’s rate or the anticipated future rate?
If you have a Traditional IRA but believe you’ll ultimately be in a higher tax bracket when ready to withdraw funds, a conversion may be best. But remember this: contributions you made to a Traditional IRA haven’t been taxed yet, so when you decide to convert, you’ll need to pay taxes on any amount that you convert from a Traditional IRA to a Roth IRA.
If you’re worried about paying a large tax bill in one year, note that Roth conversions can be done over time. You can convert just enough of your account to bring your taxable income for the year to the top of your tax bracket without jumping into a higher one. It’s a strategic way to move money from a Traditional IRA to a Roth IRA while keeping your tax liability in check. This is called tax bracket optimization.
With the taxes taken care of, your funds can grow tax-free until you decide to withdraw them or pass them on to your heirs. This is another benefit of Roth conversions for individuals and couples who seek to provide a legacy for their heirs. Money that has grown in a Roth IRA that is inherited is also completely tax-free for the beneficiaries of the account, as opposed to a Traditional IRA, where beneficiaries are required to pay income tax on any withdrawals. Keep in mind the primary aim of a Roth IRA conversion is to reduce taxes paid in the long run, which can include multiple generations.
How to Navigate the Income Eligibility Cap
By now, it’s obvious that a Roth IRA conversion has major advantages, but one drawback is that most high-income earners don’t qualify for a Roth IRA. As of 2023, you’re not eligible to contribute to a Roth IRA if you make at least $153,000 as an individual or $228,000 as a married couple. But there may still be a way to take advantage of the benefits: a “backdoor” Roth conversion.
This strategy is for those who exceed the income limits but are interested in the tax benefits. The process includes making a non-deductible contribution to a Traditional IRA and immediately converting the funds to a Roth IRA.
It’s important to note that you won’t get to use the tax deduction that often comes with a Traditional IRA contribution, but the real goal with this strategy is to get the funds into a Roth IRA for tax-free growth.
With this strategy, you gain the flexibility to control your tax burden. It allows you to smartly navigate your tax brackets and minimize your overall tax liability, which could affect how much money you really need to maintain your lifestyle in retirement.
How We Can Help
Still have questions regarding whether a Roth IRA conversion is best suited for your specific needs? That’s where we at Elk River Wealth Management come in!
Our mission is to be the indispensable partner known for delivering exceptional advice, especially when it comes to your retirement. We can help you explore your options and determine whether a Roth IRA or a Roth conversion is right for you.
Corey Gragg is the Director of Financial Planning at Elk River Wealth Management, an independent investment advisory firm that embraces a financial planning platform in order to deliver comprehensive wealth management solutions to clients in Colorado, Arizona, Nebraska, and across the United States. Corey is an experienced wealth advisor that works with individuals, families, and business owners to put together goal-based, comprehensive financial plans. What he enjoys most is working with families to provide financial independence and peace of mind through detailed planning and seeing them reach their goals. He takes his clients’ trust in him seriously and strives to continue to earn it every day.
Prior to joining Elk River Wealth Management, Corey held various sales and advisory roles with American Century Investments, located in Kansas City. Corey holds an accounting & finance degree from Washburn University in Topeka, Kansas, a Master of Science in Personal Financial Planning through The College for Financial Planning, and the CERTIFIED FINANCIAL PLANNER™ certification. Corey lives and works in Denver, Colorado. Outside of work, he loves to hike, run, golf, and spend time with family and friends. To learn more about Corey, connect with him on LinkedIn.