Tax Benefits of ROTH Conversions
There are many retirement plan choices available for today’s workforce, many of which provide tax benefits by deferring tax liability until funds are withdrawn. Common examples are 401(k) and traditional IRAs. When money is contributed, the amount gets deducted from income and results in lower taxes due for the current year. With ROTH IRAs, there is no tax benefit in the year contributions are made. However, the trade-off is your balance will grow tax-free and there will be no taxes due when funds are withdrawn after retirement age.
If money is already saved in a tax-deferred account, funds can be converted to a ROTH IRA. Since taxes were not paid when the contributions were made, the amount will need to be included in taxable income in the year of conversion. But the up-front cost can be hedged. Spreading the conversion over multiple years can help prevent the tax burden from overwhelming you all at once.
Temporary Tax Brackets Could Lead to Huge Savings
So why would you want to pay tax all this tax now instead of deferring it? With the Tax Cuts and Jobs Act passed in 2017, individual income tax brackets are lower than ever in recent history. However, these rates may only be temporary. Many of the current tax cuts for individuals are set to expire in 2025, with no indication of where rates may go. By paying tax on conversion to a ROTH now, the overall tax paid may potentially be a huge savings. Especially for younger workers who can have their accounts grow over the next couple decades tax-free.
Another difference with ROTH IRAs compared to traditional is there will be no required minimum distributions (RMDs) when you reach 70 ½ years old. Traditional IRAs require a certain amount to be withdrawn each year or you will be penalized heavily. ROTH accounts do not have those restrictions so the funds will always be available to distribute at your convenience.
ROTH IRA Income Restrictions
The downside to ROTH IRAs when compared to other retirement accounts is income restriction for making contributions. In 2019, single filers with modified AGI over $137,000 ($203,000 for MFJ) cannot contribute additional funds to directly their accounts. There is a work-around since non-deductible contributions to a traditional IRA have no income restrictions, and can then be converted to ROTH.
ROTH IRAs are a very powerful retirement tool, and when grown over a long period of time can generate immense tax savings. While tax rates are potentially lower now than when retirement comes along, converting traditional style accounts to ROTH today will help provide financial security in the years to come.