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 help 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?

“Roth” accounts were initially created In 1998 with the Roth IRA and became available in 401(k) & 403(b) plans in 2006. A Roth is an account where you do not get a tax deduction when money gets put into the account, but there can be significant tax benefits over the longer term as funds may be withdrawn tax-free when certain criteria is met. While there is an income limitation for making contributions to Roth IRA’s, there is no income limitation for making Roth deferrals to a 401(k) or 403(b) plan.

In 2010, the income limitation was removed for Roth conversions. 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. This transfer is a taxable event, meaning the amount moved from the pre-tax account to the Roth will be subject to federal and state income tax in the year of the transfer.

People close to retirement age or in the early years of retirement may want to consider making the shift and start to do Roth conversions before they reach the age when required minimum distributions (RMD’s) begin, currently age 73. Roth accounts are not subject to RMD’s. An RMD is the amount required to be withdrawn from pre-tax accounts each year after turning a specified age. The amount is calculated each year based upon the age and account balance or the pre-tax account(s).

The Tax Advantages of a Roth Conversion:

1. Tax bracket optimization.

   • With a Roth conversion, individuals can manage what tax bracket they fall within. Individuals need to assess the amount that could be converted each year to 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 may not spend what they are required to take out when they hit the required minimum distribution (RMD) age.

2. Avoid IRMAA (Income Related Monthly Adjustment Amount)

   • Medicare imposes a surcharge on the premiums for individuals with higher income referred to as IRMAA. By converting pre-tax dollars to Roth, the amount of required distributions in later years that could cause an individual to become subject to IRMAA can be avoided, or at least reduced.

3. Important for estate planning

   • With a few exceptions, most non-spouse beneficiaries that inherited pre-tax IRA’s in 2020 or later must withdraw all the traditional IRA money within ten years following death, if the original owner had already reached the age for RMD’s, the non-spouse beneficiary must take RMD’s each year based upon the beneficiaries age. For that next generation, who may be in their peak earning years, they could be paying income taxes at higher tax rates. Those inheriting a Roth IRA can leave the funds in the Roth account to grow for the 10 years after which they can withdraw the money tax-free. The annual RMD from the inherited Roth IRA account is not required.

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 potentially 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. If the retirement plan doesn’t permit in-plan conversions, they should consider making at least part of their contributions as Roth deferrals.

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 and your tax professional can help you appropriately manage these critical aspects of your portfolio to help 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, a wholly owned subsidiary of OneDigital.
These materials are provided for informational and educational purposes only and do not constitute a recommendation to buy, sell, or hold any security, nor do they constitute legal, accounting, investment, or tax advice. The materials and the information provided are not designed or intended to be applicable to any person’s individual circumstances.