A Roth IRA has a couple of significant advantages. Most notably, they allow your retirement savings to grow tax-free (as opposed to tax-deferred) and they have no required minimum distributions (RMDs). If your priority is to control your retirement savings, then a Roth IRA might be the right choice.
However, Roth IRAs have their disadvantages too, including when you roll over assets. You receive no deduction for contributions or conversions, paying full income taxes on that money. That tax spending is all capital that you could have otherwise invested, creating a significant up-front cost and potential opportunity cost.
For example, say that you have a 401(k) and are considering converting 10% of it each year into your Roth IRA. Will this help you effectively avoid taxes and RMDs? Is it wise overall? Let’s look at each of these questions in turn.
If you need help planning your retirement tax strategy, talk to a fiduciary financial advisor for free.
A Roth conversion is when you move assets from a qualifying pre-tax account, like a 401(k), into a Roth IRA. Once you make a conversion, those assets follow the rules of a post-tax account. They grow tax-free, you pay no taxes on withdrawals, and you have no RMDs.
However, a Roth conversion does come with an up-front bill. When you move money into a Roth account you must pay income taxes on the full value of the conversion. In practice, this means you add the value of the conversion to your taxable income for that year.
For example, say you convert $100,000 worth of stocks from your 401(k) to your Roth IRA. Those investments will now grow tax-free, with no taxes when you withdraw the money later in life. You would add $100,000 to your AGI for that year, and would need the cash on hand to pay the resulting income tax increase.
There is no limit to how much you can convert, although in practice it’s limited by the value of your pre-tax accounts. Nor is there any limit on how often you can convert funds. Individuals over 59 1/2 can use the converted assets to pay those taxes with no penalty, reducing the value of the portfolio in the process. Anyone younger should have another source of cash to pay those taxes. However, any assets that you convert must remain in place for at least five years before you withdraw either principal or returns. This makes a Roth conversion difficult for individuals approaching retirement. If you have questions about how the rules work, you can get matched with a financial advisor.
