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Why IRA Roth Conversions Are an Effective Way to Optimize Pre-Tax Portfolios

When it comes to preparing for retirement, there are a lot of critical decisions to be made. No matter your age, there are a few simple steps you can take to optimize your retirement savings to ensure you have adequate income in retirement.

For many years, a traditional/pre-tax option was the only way to save in a 401(k). This type of contribution encourages savings, but it can also bring challenges as it is not always the most efficient in terms of tax liabilities on those savings.

Did you know that you will only have access to a portion of your savings in your traditional IRA/401(k) because a percentage of that value will need to be paid in taxes as you take withdrawals?

Many are making the shift and are starting to do Roth conversions within their traditional retirement accounts. A Roth conversion is taking existing dollars that have never been taxed and moving that money from the pre-tax account directly into a Roth account. A Roth is an account where you pay taxes when money gets put into the account.

Investors of all ages are taking advantage of conversions and the primary considerations center around the tax advantages.

The Tax Advantages of a Roth Conversion

  1. The money can grow tax-free.

    • Because the money is taxed when funds are contributed to the account, it allows the funds to grow and compound within the IRA until they need to be taken out for retirement.
  2. When the funds are withdrawn, they can be done so tax-free.

    • When that money is taken out during retirement, it will be done tax-free. The money contributed, and all the funds that have grown within the account can be withdrawn tax-free.
  3. Tax bracket optimization.

    • With a Roth conversion, employees can perfect what tax bracket they fall within. Individuals need to assess the amount that could be converted per year and stay in the same tax bracket. What is the amount that can convert without pushing them into a higher bracket? For those with significant pre-tax dollars, it's imperative because some individuals will not spend what they are required to take out when they hit RMD age.
  4. Important for estate planning

    • There is a new rule for IRAs that non-spouse beneficiaries must withdraw all the traditional IRA money within ten years following death. Which could be in their peak earning years, and therefore would be paying income taxes at the highest tax rates, unlike a Roth where the children can withdraw the money tax-free.

Converting traditional pre-tax funds to after-tax Roth is not exclusive to just those on the verge of retirement. Young people can also take advantage of this opportunity while their income/tax bracket is presumably lower than it will be in the future. By initiating a Roth conversion now on their pre-tax retirement money, they can take advantage of the benefits of the tax-free growth for many more years.

Additionally, many corporate retirement plans now include the ability to make Roth contributions inside the plan. Making the decision to contribute in this way could be made for the same set of reasons discussed above.

There are many things to consider when thinking about a Roth conversion, including your time until retirement, your projected savings and distribution plan, your current and future income and tax bracket and even your predictions on the future individual tax-rates. A licensed financial adviser can help you appropriately manage these critical aspects of your portfolio to ensure that you have adequate savings, managed efficiently to work towards maximum flexibility and return in retirement.

Check out this recent blog post “Employee Retirement Savings Plan Alternatives,” or connect with a OneDigital wealth management team member to learn more.

Investment advice is offered through OneDigital Investment Advisors, an SEC-registered investment adviser and wholly owned subsidiary of OneDigital.