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Everything You Need to Know About Roth Conversions

Retirement is a goal that most of us share. Our retirement years bring new opportunities for travel, personal growth, and spending precious time with the ones we love. Regardless of where you are in your life and career, making smart decisions that prioritize your long-term financial wellbeing can help you retire comfortably. 

Can a Roth IRA conversion help you reach your retirement goals? In this article, we’ll explain how Roth conversions work, discuss the benefits and potential drawbacks, and explore when and how this type of transition can be a sound financial decision.

What is a Roth Conversion?

A Roth IRA conversion involves transferring your retirement assets from a traditional IRA, SEP IRA, SIMPLE IRA, or 401(k) into a Roth account, which creates a taxable event. Since other types of retirement accounts are tax-deferred (taxed at the point of withdrawal) while Roth IRAs are pre-taxed, any previously deferred income taxes must be paid at the time of the conversion.

This is why Roth conversions are often a beneficial strategy for people who have substantial retirement savings and expect the deferred tax liability in their traditional retirement account(s) to grow prior to or at the time they plan to begin making withdrawals. Since a Roth IRA allows you to make tax-free withdrawals of qualified distributions, this is an advantageous strategy for people who anticipate their tax bills to increase in the future.

How Does a Roth Conversion Work?

A Roth conversion is achieved by: 1) paying taxes on your contributions and gains, and 2) converting your retirement account to a Roth IRA. Only post-tax dollars may be transferred into your new Roth account. Therefore, if you took deductions on your prior contributions, you’re required to pay back those deductions at the time of conversion, in addition to any investment gains, when you file your tax return for the relevant year.

Once you’ve paid these taxes, you can then transfer your retirement funds into your new Roth IRA. If you don’t already have a Roth account, you can open one at the time of the conversion with the help of your IRA administrator. The funds can be converted using one of three approaches:

  1. An indirect rollover: This approach allows you to receive a distribution from your current retirement account and then contribute those funds to a Roth IRA within 60 days.
  2. A trustee-to-trustee (direct) rollover: The financial institution holding your current retirement assets can transfer your funds directly to your IRA provider through this method.
  3. A same-trustee transfer: If your existing funds are at the same firm as your Roth IRA, the financial institution can simply transfer specific funds from your existing account(s) to your Roth.

3 Advantages of Doing a Roth Conversion

Tax-Free Growth & Withdrawals in Retirement

Although a Roth conversion represents a taxable event at the time of the transfer, you benefit from tax-free growth for the remainder of your pre-retirement years. In addition, since Roth IRAs are tax-exempt, any contributions you make after your Roth conversion and any investment gains you accumulate can be withdrawn tax-free during your retirement.

No Required Minimum Distributions (RMDs)

Traditional IRAs have required minimum distributions (RMDs) every year after you reach the age of 72. That means you’re required to withdraw a certain amount annually, regardless of whether you need the money. Roth IRAs, on the other hand, have no RMDs, so any money you don’t need can remain in your account and continue to grow.

Things to Consider Before Doing a Roth Conversion

5-Year Rule

Although Roth IRAs are less restrictive than other types of retirement accounts and are accompanied by a variety of tax benefits, there is a 5-year waiting period on certain types of withdrawals. This is commonly referred to as the “5-year rule.” That means after you’ve converted a traditional IRA to a Roth, you must wait 5 years to withdraw funds or pay income taxes on your earnings and incur an additional 10% penalty.

May Have to Pay Taxes Upfront

As discussed previously, a Roth conversion represents a taxable event. This means, unless you choose to take advantage of the charitable deduction benefit, you will be required to pay taxes on any assets for which you originally took deductions.

Social Security May Be Taxed

When your combined income for Social Security purposes is above the threshold ($34,000 for individuals or $44,000 for couples), up to 85 cents of each Social Security income dollar you receive may be taxed. In some cases, a Roth conversion could cause your total income to rise above this threshold, resulting in social security taxes.

Identify the Strategies Suitable For You To Work Towards Your Retirement Goals

Are you wondering if a Roth conversion is right for you? At Chatterton & Associates, we work to build long-term relationships with our clients. This allows us to accumulate a depth of knowledge regarding your individual goals and help you craft a comprehensive financial strategy now and in the future. We take into account your specific circumstances, risk tolerance, timeline, and individual goals and preferences in order to develop a personalized approach to financial planning.

Contact us today to set up a private, one-on-one consultation and tell us how we can help.


The Team at Chatterton & Associates

Although the information has been gathered from sources believed to be reliable, it cannot be guaranteed. Federal tax laws are complex and subject to change. This information is not intended to be a substitute for specific individualized tax or legal advice. Neither Royal Alliance Associates, Inc., nor its registered representatives, offer tax or legal advice. As with all matters of a tax or legal nature, you should consult with your tax or legal counsel for advice.

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