Roth Conversions: One Powerful Financial Planning Tool

Are tax rates going up? Will future tax law change favor or be detrimental to the taxation of our 401(k)s and other tax-deferred accounts? Who really knows the answers to these and other tax related issues? 

What is a Roth Conversion?

One powerful financial planning tool to consider in such an uncertain tax environment is a Roth conversion, especially if you see taxes going up in the future.

Roth conversions involve the process of converting some or all of your pre-tax IRA or 401(k) retirement accounts into an after-tax Roth IRA account. Anyone can convert their eligible pre-tax assets to a Roth IRA regardless of income or marital status. This is in spite of the fact that one’s income may be too high to currently contribute to a Roth on an annual basis. Currently, there are no limits on the number and size of Roth conversions you can make from a traditional IRA.

Roth IRA Withdrawal Requirements

Generally, a Roth IRA conversion may not make sense if your time horizon is less than 5 years. This is because there is a 5 year “aging requirement” (or until age 59 ½, whichever is later) from the beginning of the calendar year of your Roth conversion deposits before those Roth IRA moneys may be withdrawn without a 10% penalty. Other exceptions to this 10% penalty include making a qualified first-time home purchase, disability, or death. Under what is called, “the 5-year rule” each conversion to a Roth account has its own 5 year holding period mandated in order to receive penalty free distributions.

“Laddered Roth Conversion” Strategy

Many investors have utilized the Roth conversion tool for their large traditional IRA or 401(k) balances over a period of several years in a “laddered Roth conversion” strategy. The amount of conversion can depend on many other factors such as your income level, tax losses, deductions available, and the equity markets levels in the year of conversion.

Benefits of a Roth IRA

Investments within a Roth IRA grow tax-free and have no required minimum distributions (RMD’s) during your lifetime. As long as you are earning income you can keep contributing into your Roth into your 70’s and beyond, regardless of age. From there you can continue to let that money grow and pass it to your heirs one day tax-free.

Disadvantage of a Roth IRA

You do pay taxes on your conversion from a traditional IRA to a Roth IRA and if you have a required minimum distribution (“RMD”) that is due, you must take that RMD before converting to a Roth IRA.