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Roth IRA and 401k Conversions: What you need to know.

December 08, 2023

As we come to towards the end of another year, its time to talk a little bit about Roth conversions. If anything, Roth conversions give you some additional control over taxes in the future. One strategy I employ with clients is to think about the risk of not knowing what taxes will be in the future. In a way, you can hedge your risk by paying taxes now vs. later on. For some clients the anxiety of taxes in the future bother them more than taxes now. For each client I have the discussion about how they feel about taxes, what their tax bracket is and some of the pros and cons of converting now or in the future. 

Here are my top 5 reasons for why you might consider a Roth Conversion:

  1. Tax Diversification:

    • Diversifying your retirement savings across different tax treatments can provide flexibility in managing your tax liability in retirement. Traditional IRAs and 401(k)s are tax-deferred, meaning you pay taxes on withdrawals. Roth IRAs, on the other hand, are funded with after-tax dollars, and qualified withdrawals are tax-free. By converting some funds to a Roth IRA, you create tax diversification and have the option to choose where your withdrawals come from in retirement based on tax considerations.
  2. Tax-Free Growth:

    • Once the funds are in a Roth IRA, they can grow tax-free. Unlike Traditional IRAs, where withdrawals are taxed as ordinary income, qualified withdrawals from a Roth IRA are tax-free. This can be particularly advantageous if you expect your tax rate to be higher in retirement or if you anticipate substantial growth in your investments.
  3. No Required Minimum Distributions (RMDs):

    • Roth IRAs are not subject to required minimum distributions (RMDs) during the lifetime of the original account owner. Traditional IRAs and 401(k)s require account owners to start taking minimum distributions once they reach a certain age (currently 72). By converting to a Roth IRA, you can potentially reduce or eliminate RMDs, giving you more control over your retirement income and potentially leaving more for heirs.
  4. Estate Planning Benefits:

    • Roth IRAs can be an effective tool for estate planning. Since Roth IRAs don't have RMDs during the account owner's lifetime, the funds can continue to grow tax-free, potentially providing a tax-free income stream for heirs. Additionally, heirs who inherit a Roth IRA can benefit from tax-free withdrawals, provided the account has been open for at least five years.
  5. Managing Future Tax Liability:

    • If you anticipate higher taxes in the future, either due to changes in tax laws or changes in your personal financial situation, doing a Roth IRA conversion allows you to lock in current tax rates on the converted amount. While you will pay taxes on the converted funds in the year of the conversion, future qualified withdrawals will be tax-free, potentially saving money in the long run.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax or legal advice. We suggest that you discuss your specific situation with a qualified tax or legal advisor. Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA. A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.