Is Now the Time for a Roth Conversion?

When talking with your CPA or Advisor, you may have heard of the term "Roth Conversion". Let's talk about what that means, what the benefits are, and if it’s something you should be considering.  

What is a Roth IRA Conversion?

A Roth IRA Conversion is the process of converting a Traditional IRA to a Roth IRA.  If you don't remember the difference between those two, a Traditional IRA is a retirement account where you get a tax deduction for whatever you contribute (up to the annual limit), but you will pay taxes on all of it when withdrawn at retirement. A Roth IRA is a retirement account where you don't get a tax deduction for contributing to it, but when you withdrawal from the account upon retirement, none of the contributions you made, nor the earnings on those contributions, are taxed! 

So the philosophy behind a Roth Conversion is that whatever money you have sitting in a Traditional IRA (remember, money that has not been taxed yet), you can take a part or all of that, and pay taxes on it today. But then you’re done paying taxes on it! It can continue to grow tax-free. So when you withdrawal at retirement, the money isn’t taxed!

When would a Roth IRA Conversion be beneficial?

If you expect your tax rate to be higher in the future than it is today, it may be advantageous to convert now. For instance, let's say I'm in the 22% tax bracket today, but I expect to be in the 32% tax bracket when I retire (based on expected income, future tax rate changes, etc.). Well when I convert from the Traditional to the Roth, I pay taxes on all of that now (at 22%), instead of later (at 32%). So if I truly do expect my tax rate to be higher in the future, I'm better off paying those taxes today, at the lower rate, than in the future, at a higher rate. It's similar to good nutrition and exercise, you pay the small price of discomfort now to avoid the bigger price of poor health later in life. 

The reason this has been getting so much attention lately is because we are in a historically low tax rate environment right now. Based on the mounting debt of the United States and the price of the economic stimulus packages, it's very likely that in 20-30 years (maybe even 5-10 years), tax rates are going to be higher than they are today, thereby making a Roth IRA Conversion now, at lower rates, an attractive strategy.

A few things to consider

You will have to pay taxes today on anything you convert - so will likely have a much higher tax bill than you’re used to, depending on how much you convert. You also need to be conscious of managing your tax bracket as well, because anything you convert will get added to your income and potentially push you into a higher tax rate. So you may need to spread these conversions out over time to manage your tax bracket. Finally, there is the risk that tax rates are actually lower in the future (although I personally think that risk is low, but it’s a risk nonetheless).

Of course, none of this is intended to be tax advice in any way, but this is something that you should discuss with your CPA and/or advisor. Depending on your situation, this could potentially save you tens of thousands of dollars over your lifetime; however, it must be done with proper guidance and planning. And the price of a CPA is a fraction of the amount you could save with proper planning. There are some Roth conversion calculators out there that can give you an idea on tax implications, but you really need to be working with a professional on this. So ask your CPA if a Roth IRA Conversion is right for you!

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