Tax Strategies Behind Roth IRA Conversions
This post was last updated on December 30, 2023, to reflect all updated information and best serve your needs.
Saving money for retirement is critical, but not everyone knows how to do it effectively. You should already understand the value of building a nest egg for your golden years. However, when it comes to the types of accounts you have, it can start to get a little confusing. 
Individual retirement accounts (IRAs) are the most common options for those looking to save money, and there are two primary kinds - Roth and Traditional. In this article, we want to compare the two, particularly when it comes to paying taxes.
Assuming that you don’t want more of your money going to Uncle Sam, you need to utilize various tax strategies. Specifically, we’re going to look at your options when converting a traditional IRA to a Roth.
Roth vs. traditional IRAs: A Primer
Before you can understand the various advantages (and potential pitfalls) of a Roth IRA conversion, you need to know the primary differences between the two accounts. Here is a brief overview.
Income Restrictions
There are no income restrictions to contribute to a traditional IRA. However, there are income restrictions on whether or not you can deduct the contributions from your taxes.
For Roth IRAs, however, you could potentially make too much money to open one. In 2024, individuals making at least $146,000 (modified adjusted gross income, or MAGI) will start to have restrictions. Anyone making over $161,000 cannot contribute to a Roth at all. For couples, restrictions begin at $230,000 and phase out entirely at $240,000.
Distributions
Because traditional IRAs are designed to help you earn money in retirement, they come with required minimum distributions (RMDs). Most tax-sheltered retirement accounts have these, and they are calculated based on a complicated formula from the IRS. The rule used to be that anyone over age 70 1/2 had to start taking RMDs, but the law changed in 2019 and again in 2022. Now, individuals can wait until 73 (75 starting in 2033).
With Roth IRAs, however, there are no required distributions. The money in your account can continue to grow tax-free for as long as you live. This also means that you can pass the funds down to your heirs if you like.
Another element of the recent IRA change is that recipients of Roth IRAs now have to withdraw the money within 10 years. Before, they could hold onto it for as long as they like, but now that’s not the case.
Contribution Limits
Both IRA accounts limit the amount you can put in within a given tax year. In 2024, the maximum total is $7,000. However, if you’re over 50, you can add another $1,000 to “catch up” for retirement. Keep in mind that the total is across both kinds of accounts - you can’t do $7,000 per IRA. The total contribution between Roth and traditional IRAs is $7,000.
Withdrawals
Again, traditional IRAs are designed to help you have money for retirement. Because of that, they will charge stiff penalties if you try to take any funds out before age 59 1/2. Typically, you will have to pay taxes on the income (more on that later), as well as a 10% penalty.
That being said, you can usually withdraw money from your IRA at a younger age for specific life events, such as buying a house or paying for medical bills. You will need to talk with your financial advisor to see if and when you qualify for these penalty-free withdrawals. As a rule, you can take up to $10,000 of your investment earnings as long as you've held the account for at least five years.
For Roth IRAs, any contributions you make can be taken out both tax-free and without penalty. Taxes and fees will only take effect on any earnings from the account. However, as with a traditional IRA, these penalties only happen if you’re younger than 59 1/2.
Tax Breaks
Here is where we get to the meat of the issue. Depending on your particular situation, you can take advantage of the different tax rules between traditional and Roth IRAs. Let’s break down the primary difference between them before getting into the various tax strategies for a Roth conversion.
Traditional IRAs - Tax Deductible
When you put money away in a conventional IRA, you can deduct the funds from your modified adjusted gross income (MAGI) as long as you qualify. This means that your tax bill for any given year could be reduced. Those who are close to getting into a higher tax bracket can take advantage of this to ensure that they don’t owe more to the government.
On the back end, when you withdraw funds from your IRA, you will be taxed. Fortunately, your tax rate will be based on your current income, not your rate when the money was put in. For most retirees, their earnings are substantially less in retirement, so they wind up saving more money overall.
Roth IRAs - Tax-Free Withdrawals
These accounts function in the opposite way of traditional IRAs. Rather than deducting your contributions now, you will still have to pay taxes on your earnings for the year.
However, the benefit is that you don’t have to pay them when taking money out of the account. As you’ll recall, any contributions can be withdrawn without penalties or fees. Earnings, however, will be taxed if you’re not at least 59 1/2.
In both cases, the money in your account grows tax-free. Although you will have to pay income taxes on withdrawals from a traditional IRA.
Why Convert to a Roth IRA?
As you can see, there is potentially a benefit to putting more of your money into a Roth IRA. Once you reach the required age, you can take all of your cash out without incurring taxes or fees. Not only that, but you can let your money grow longer, as there are no required distributions.
However, not everyone can take advantage of these accounts. Let’s look at a few scenarios to help you understand when to convert to a Roth and when it might be a bad move financially.
How Roth Conversions Work
There are three options when converting money from a traditional IRA to a Roth.
- 60-Day Rule - in this case, you withdraw money from your IRA via check, and then put it into a Roth IRA within 60 days. If you don’t, then you have to pay taxes on it and incur a penalty (assuming that you’re not 59 1/2).
- Trustee to Trustee - if you are using two financial institutions, have the one managing your traditional IRA rollover funds to the one handling your Roth.
- Same Trustee Transfer - for those who have both accounts with the same financial institution, you can convert funds much easier, as they don’t have to transfer from one place to another.
Paying Taxes On Your Conversion
At first, it may seem like you could avoid paying taxes altogether when moving money from a traditional IRA to a Roth. After all, you deducted the initial contribution from your MAGI, and you don’t have to pay taxes on withdrawals from your Roth account.
Unfortunately, the IRS will still make sure that the government gets its cut. Typically speaking, the amount of money you convert will be added to your total income for the year, assuming that the funds were deducted in previous years.
An alternative to that would be to convert money from a traditional IRA in the same year you contributed. Since you never claimed the deduction, you don’t have to worry about inflating your overall income for the year. This is what’s typically called a Roth IRA Conversion.
The IRS also has what’s called a pro-rata rule. Under this rule, you can claim some of your IRA deduction, but the bulk of your conversion amount could still be taxed.
No matter what, you'll pay taxes when converting money into a Roth IRA, so you need to keep that in mind. One of the worst things you can do, though, is to pay your tax burden with funds from your retirement account. Not only will doing that lower your overall amount, but you will lose out on the investment earnings over the long term.
So, if you are thinking of doing a conversion, you need to make sure that you can pay the taxes from a separate account. If you can’t make the payment in a given year, then it’s not a good idea to convert.
Current vs. Future Tax Rates
Another reason to consider converting money to a Roth IRA account is that you believe that your tax rate will be higher in the future. Even in retirement, your earnings could be substantial, as the IRS considers income from a variety of sources. Some examples of non-career based earnings can include:
- Investment Income - if you have money in stocks and other investments, you will likely have to worry about capital gains.
- Rents and Royalties - owning a rental property ensures that you maintain passive income throughout retirement. This money is still part of your MAGI, though.
- Social Security - the government will start paying you once you file. This money is considered income by the IRS.
- Pensions and Annuities - pension plans offer guaranteed monthly income based on your earnings while you were working. Annuities can come from various sources, including life insurance policies.
- Inheritance - realistically, you will only have to worry about inheritance for a single tax year. However, if you get disbursements from a trust fund, that income can still be counted for tax purposes.
Overall, if you believe that your tax burden will be higher in retirement, then converting to a Roth now will make sense, provided that you have enough money to pay the government at the time of conversion.
Alternatively, if you think that your tax rate will be lower in retirement, it might be better to put money away in a traditional IRA instead. Depending on the difference between your tax rates, you could potentially save thousands of dollars in the long run.
Contact NextGen Wealth Today
Moving money between retirement accounts is relatively straightforward, provided that you do it correctly. In many cases, not knowing the rules or your total tax burden could put you in a bad situation. So, before attempting anything, be sure to speak to an expert.
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