Evaluating Retirement Savings: The Benefits of Converting to a Roth IRA
As the year draws to a close and we prepare for the new Congress, it’s the perfect moment to reflect on your retirement savings strategy—particularly the potential benefits of converting some of your traditional IRA funds into a Roth IRA. Financial decisions of this nature are significant and should ideally be made with the guidance of a financial advisor; however, many experts view this as a strategic opportunity, especially in light of the current tax landscape.
Understanding Roth IRA Conversions
A Roth IRA conversion is essentially the process of moving funds from a traditional IRA to a Roth IRA. To clarify:
- Traditional IRA: Contributions to this account are usually tax-deductible, meaning you pay taxes on the money when you withdraw it during retirement.
- Roth IRA: Contributions here are made with after-tax dollars, allowing for tax-free withdrawals in retirement under certain conditions.
The main takeaway is that by converting to a Roth IRA, you pay taxes on the amount converted now, but you lock in tax-free withdrawals later.
The Certainty of Today’s Tax Rates
One of the most compelling reasons to consider converting your traditional IRA to a Roth IRA is the concept of tax certainty. Current tax rates are a known quantity, and for many, they are historically low—lower than they’ve been in years past. This is largely due to the Tax Cuts and Jobs Act of 2017, which introduced reduced tax rates that are set to expire after 2025 unless renewed by Congress.
With the uncertainty surrounding a new Congress and potential changes to tax laws, locking in today’s tax rates could be a smart move. Many financial experts caution that it is unlikely we will see tax rates drop even further; in fact, rates may rise in response to growing national debt and other fiscal needs.
When a Roth Conversion Makes Sense
While a Roth conversion can provide long-term benefits, it isn’t suitable for everyone. Here are some groups for whom converting might be especially advantageous:
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Future Higher Tax Bracket: If you expect to be in a higher tax bracket in the future, either from increasing income or changes in tax legislation, converting now at a lower rate may save you money in the long run.
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Lower Taxable Income in Retirement: Roth IRAs allow for tax-free withdrawals. This can help you strategically manage your income in retirement, potentially lowering tax liabilities on Social Security benefits or Medicare premiums.
- Tax-Free Inheritance: A significant advantage of Roth IRAs is that they do not require minimum distributions during the account holder’s lifetime, letting the account grow tax-free. Additionally, heirs can inherit the account without incurring taxes.
Important Considerations Before Converting
Despite the advantages, a Roth conversion does come with its own set of considerations that warrant careful deliberation:
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Tax Implications: When you convert, you will owe income taxes on the converted amount. If this amount is substantial, it could push you into a higher tax bracket for that year. It is usually advisable to cover any tax owed with cash outside of your retirement savings to preserve your investment.
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Timing: Timing is crucial. If you anticipate a year where your income is lower—perhaps due to a temporary reduction in salary or a break from work—this could be an ideal time to execute a conversion. Conversely, if you expect significant income, such as a bonus, you might want to plan your conversion around those events to minimize tax impact.
- Financial Consultation: Engaging with a financial advisor or tax professional before making such decisions is critical. They can assist in evaluating your specific situation and help you devise a tax-efficient strategy for your Roth IRA conversion.
Conclusion
With current tax rates hovering at historical lows and an increasing possibility of tax policy changes in the future, now may be the right moment to consider converting some of your traditional IRA assets to a Roth IRA. This can offer significant benefits in the long run, provided the decision is informed and strategically planned.
Rodney M. Loesch, CFP, CDFA, is a Senior Partner at LifeGoals Strategies Group in Lee’s Summit and a member of the Financial Planning Association of Greater Kansas City. He provides securities and advisory services through LPL Financial, a registered investment advisor and member of FINRA/SIPC.
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