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How Roth Conversions Affect Retirement Savings


How Roth Conversions Affect Retirement Savings

A Roth IRA can be a great way to grow your retirement savings. At the same time, it should never be considered a one-size-fits-all solution. Roth conversions allow you to change your traditional IRA into a Roth IRA, which can be beneficial under certain circumstances. However, there are many things that need to be considered before you make the decision to do a Roth conversion.

This guide discusses some of the reasons why you may want to do a Roth conversion, the resulting potential benefits, and the resulting possible drawbacks. Overall, we are taking a look at how converting an IRA can impact your future retirement savings.

This article covers the following about Roth Conversions:

  • The potential benefits of converting a traditional IRA
  • Why a Roth conversion is not a one-size-fits-all solution
  • Possible drawbacks of Roth conversions and Roth IRAS
  • How the IRS treats traditional IRAs vs Roth IRAs
  • Why timing your conversions can be crucial
Chapter 1

What Is a Roth Conversion (RC) and How Do They Affect Retirement?

A Roth conversion (RC) occurs when you take a portion of your traditional IRA or 401(k) and convert it to a Roth IRA. The benefits of making this move include the fact that you can pay taxes on the earnings when you convert (rather than later in retirement). 

Additionally, there is no limit on how much money you can convert—so long as you can stomach the tax bill. 

When considering whether or not to do an RC with your retirement savings, it is important to weigh all of these factors against each other:

- How much should I be converting now?
- When is the ideal time to make a Roth conversion?
- What impact will this have on my nest egg?
- How much am I going to need in my retirement years?

Roth IRAs are retirement savings accounts that allow for tax-free and penalty-free distributions (withdrawals), as long as you follow the rules. For example, if you are 44 years old and have $150,000 in an IRA, you will be able to convert all or part of that amount into a Roth IRA, which will then be taxed as ordinary income at the time of its conversion. 

You are assessed taxes on the amount of money that you convert and if you feel tax rates are going to increase in future years, then it might make sense to consider a conversion over the coming years.

Chapter 2

Tax Implications: Will I Pay More Taxes if I Convert to a Roth IRA?

Yes. Well, at least in the short term. But that is where the magic of a Roth conversion comes in.

With a traditional IRA, your earnings grow, tax-deferred until you withdraw them in retirement. However, with Roth IRAs, you pay taxes upfront—and the earnings and subsequent withdrawals are not taxed at all. 

As a result, if you are planning to convert a traditional IRA and you are considering this source of funds for retirement savings, review your current tax bracket to see if there is room to convert at your current tax bracket. A Roth conversion is only advisable if the amount being converted is not so large that it pushes you into a higher tax bracket (than the one your current paycheck is taxed for).

There are additional ways to potentially reduce your tax liability, as well. To contribute money to a traditional IRA, you need to have earned income and be under the age of 70½. There are no further requirements for contributing so this may be a way to potentially reduce your taxable income for that year.

The overall benefit is managing the tax you pay and the aforementioned growth within those accounts is tax-deferred until withdrawal (and then it is taxed as ordinary income). However, when you make a withdrawal from an IRA before the age of 59½, you are normally required to pay an additional 10% penalty on top of all other taxes owed on those funds.

You may avoid paying additional taxes right now by putting off withdrawals and/or conversions until later. Bear in mind: if things go wrong financially or health-wise while you are retired or semi-retired (and thus not earning much), you may be stuck with retirement savings that haven’t been taxed yet. It’s important to have a good blend of pre-tax and post-tax savings for reasons like this.

Generally speaking, if your income has been rising steadily over time, then converting your IRA to a Roth may help save you taxes later in life (when you may be earning higher amounts). However, if this is not the right step for you, you can wind up paying more in taxes and creating other problems for yourself. Please consult a fiduciary wealth manager in regard to your long-term financial plans before committing to a decision.

Chapter 3

Timing: RCs in Retirement vs After Leaving Your Job (Having To Deal With 401(k))

A 401(k) can help you save for retirement and get tax deductions, but just like any other investment account, it needs careful monitoring. One of the most important things to do when you retire is to find a good financial advisor. You will want to work with someone who has been in the business for a while, preferably with at least 10 years of experience. 

They should also have experience working with retired people and their unique circumstances. You need to begin by determining your allocation between stocks, bonds, and cash. This will be influenced by the amount of risk you can tolerate and your time horizon: The longer your time horizon, the more you may want to invest in stocks.

The next step is determining how much of your portfolio to invest in each asset class. For instance, imagine you are investing $10 million into stocks with a 60% allocation and 40% allocated elsewhere. This means that $6 million is being allocated to stocks, while $4 million is being allocated elsewhere. 

Especially during market volatility, diversification is important, as well. This involves considering—not just which assets to acquire, but—what types of assets you want within those allocations, such as real estate or mutual funds. You may even want to consider alternative investments, such as commodities (like aluminum, peaches, or precious metals). 

Conversely, you may also want to discuss a strategy for taking money out of your accounts, should you need to. If, for example, you lost your job, you would need to be able to cover your rent or mortgage payments. The ideal time to consider these things is when everything is going well (or reasonably), financially. Waiting until your money life has gone sideways inhibits your ability to make calculated and measured money-managing decisions.

If the worst were to happen, hopefully, you would not spend money you do not have already in your bank account or checking account. The same applies to retirement income from your 401(k) or IRA plans. If at all possible, that money should be considered inaccessible until you have reached retirement age. 

So, get proactive; pursue informed investing here and now, while the pressure is off. This is usually a much better game plan. It may make you make your money grow as well, which can potentially contribute to your financial security in retirement.

Chapter 4

Stopping the Clock: RC and Legacy Gifting

A Roth conversion can be one of the greatest tools available to those in a high tax bracket.

Gifting money directly by check or transfer from a bank account is easy. However, there are other ways to make lifetime donations that may offer tax benefits (in addition to possibly minimizing estate taxes later). 

One method is making a qualified charitable contribution (QCD) with appreciated assets such as stocks, bonds, and mutual funds that have increased in value since they were purchased. Gifting long-term assets outright to your favorite charity, unlike donating cash, can allow the recipient to benefit from your gift’s current market value. 

Meanwhile, doing so may also entitle you to significant capital gains and tax savings (as much as 20%, in some circumstances). Selling a property and then contributing its after-tax proceeds tends to be far less beneficial for both philanthropists and the causes they enjoy giving to.

Chapter 5

Roth Conversions and RMDs Explained


You will be able to take distributions from your Roth IRA at any age. 

These mandatory withdrawals are a set percentage of money that must come from your traditional IRA, 401(k), or another qualified retirement account each year. The money remains yours, but it has to be removed from the account’s tax-deferred status and moved to a taxable account.

Going through the process of retirement can be overwhelming, but it can also be a great learning experience. When you are able to answer the common questions that come up for people in your position, you will have a better understanding of how to handle your own retirement needs.

Chapter 6

Investing Your Retirement Income Into a Roth IRA or 401(k)

As you can see, there are many factors that determine whether or not a Roth IRA is right for your financial situation. While many people find that the immediate benefits of a traditional IRA outweigh their counterparts, some investors do benefit from converting their pre-tax retirement savings to Roth contributions.

A Roth IRA can be ideal for reducing the amount of taxes you owe from investments early in life or for those who do not have access to a 401(k) plan through their employer. To find the best solution, a financial advisor is a great resource for helping you assess your needs—and warning you against potentially costly mistakes.

Whether to invest for retirement in a Roth IRA or a 401(k) is a decision facing nearly every working American. Each choice can be beneficial in its own right. Meanwhile, there are key differences between the two:

  • A Roth IRA allows for tax-free growth on earnings and withdrawals in retirement. Contributions made to your account are not tax deductible. However, qualified distributions are generally exempt from taxes (with some exceptions);
  • A Roth 401(k) allows for tax-free growth on earnings and withdrawals in retirement. At the same time,  they allow for higher limits consistent with qualified employer plans. Contributions may be partially or fully deductible, depending on factors such as your income level and whether or not you participated in an employer-sponsored plan already.

There are also similarities between the two; the biggest is they have both been taxed and can then be withdrawn tax-free in retirement. The dividing line runs between how much you can contribute each year and how your contributions are treated by the IRS at different phases of your working life.

Additionally, because both accounts allow for tax-free growth, they can provide excellent ways of pursuing growth for your net worth: When you withdraw the money from them, you are assessed no taxes on your gains or earnings. Instead, your investments can continue to grow without being taxed.

If you have a substantial amount of money in your 401(k) or traditional IRA account, it may make sense to do a Roth conversion, pay taxes on the withdrawal now, and leave a bigger part of your inheritance in a tax-free account. To better your odds of making optimal choices, you need an experienced tax professional who knows Roth rules and can help you make well-informed decisions in regard to your retirement nest egg. 

TrustCore Financial Services has both of these bases well covered. If you are looking to hire a financial advisor—or you are currently between wealth advisors—our track record speaks for itself. We are fiduciaries, which means that we are legally committed to putting your best financial interests first, even if that were to conflict with our own. 

Our clients can tell you why we are esteemed among financial advisors in Nashville, TN. Schedule a complimentary meeting today. Put our investment strategies to work for you.

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