Emma and Sean had diligently saved for their retirement throughout their careers, consistently deferring the maximum amount to their employer 401(k) plans. As such, they finally felt comfortable in retiring. Right after retirement, Emma’s mother passed away. Unbeknownst to Emma, her mom left her a sizeable inheritance. In talking with her financial advisor, Emma wanted to know how to best utilize her inheritance and retirement accounts. Her advisor started talking to her about Roth conversions for her new Rollover Individual Retirement Account (IRA). Emma had never heard of this strategy so was eager to learn more. Below we will explore what a Roth conversion is, benefits, drawbacks, and considerations in determining if it’s the right strategy for you.

A Roth conversion involves transferring or moving funds from a traditional IRA to a Roth IRA. Unlike Traditional IRAs, which are funded with pre-tax dollars, Roth IRAs are funded with after-tax dollars. Thus, with a conversion you will pay taxes on the converted amount in the year of the conversion. After that, the funds grow tax-free. Additionally, when you withdraw these funds in retirement, the withdrawals are also tax-free, unlike in a traditional IRA where you pay taxes when you withdraw the funds.

• Tax-Free Growth: One of the most compelling reasons to consider a Roth conversion is the tax-free growth potential on the assets. Once you’ve paid taxes on the converted amount, all future earnings withing the Roth IRA are tax-free.
• Tax-Free Withdrawals: Qualified withdrawals from a Roth IRA are tax-free. This can result in significant tax savings during retirement.
• No Required Minimum Distributions (RMDs): Traditional IRAs require you to start taking RMDs at a specific age (72 or later). Roth IRAs, however, do not have RMDs during the account holder’s lifetime. This can allow for the investments to continue growing tax-free for as long as you like.
• Estate Planning Tool: As there are no RMDs, Roth IRAs can be a valuable estate planning tool. These funds can often be an ideals asset to leave to your heirs, as they can benefit from tax-free withdrawals.

• Tax Liability: In the year you convert funds from a Traditional IRA to a Roth IRA, there is a tax liability on the converted amount. This could potentially push you into a higher tax bracket, to mitigate this impact the amount you convert should be strategically planned out.
• Impact on Financial Aid and Medicare Premiums: Increased income from a Roth conversion could affect aid calculations for your children for college. In addition, higher income can increase your Medicare Part B and Part D premiums.

• Timing: The timing of the year of your Roth conversion plays a crucial role. As conversions affect your tax liability, it’s beneficial to convert during a year when your income is lower. Additionally, converting towards the end of the year can be advantageous because you’ll have a clearer picture of your overall financial situation, including wages, income, dividends, and capital gains. This approach helps ensure that the amount you convert keeps you within your desired tax bracket.
• Current v. Future Tax Rates: Considering what tax bracket you may be in now verse the future can help determine if a Roth conversion makes sense. If you believe your tax rate will be higher in retirement, converting funds now might be a good option.
• Maximizing Tax Brackets: There is no requirement on the amount of funds converted each year. Thus, converting enough funds each year to stay withing a specific tax bracket is ideal.
• Paying the Taxes: Roth conversions create tax liability. As such, it’s ideal to have funds outside of your retirement accounts to pay the taxes on the conversion. Utilizing funds from your retirement accounts to pay the taxes can negate some of the benefits.

1. Consult a Financial Advisor: Before making any decisions, consult your financial advisor or tax professional to further understand the implications and develop a strategy that aligns with your financial goals.
2. Calculate the Tax Impact: Determine the tax liability of the conversion. We usually recommend working with a tax advisor to get precise calculations.
3. Initiate the Conversion: Work with your financial advisor or contact your financial institution to initiate the transfer of funds from the Traditional IRA to a Roth IRA.
4. Pay the Taxes: Prepare to pay the taxes on the converted amount by the tax deadline for the year of the conversion. This may require adjusting your withholding or making estimated tax payments

After learning more about the Roth conversion strategy, Emma and Sean took time to discuss whether it was the right choice for them. After carefully considering their options, they decided to move forward with the strategy. They identified a few key reasons for this decision. First, over the next several years, they would be in a relatively low tax bracket before being required to take mandatory distributions from their IRAs. This will allow them to maximize their low tax bracket by completing the conversions during this period. Second, they anticipated due to their inheritance, there wouldn’t be a significant need to withdraw or utilize funds from their IRAs anymore. This made converting the funds to a Roth IRA particularly advantageous for their children, who would then inherit the funds tax-free. Lastly, they realized the inheritance would provide them with the necessary funds to cover tax obligations associated with the conversions.

Roth conversions can be a powerful tool for retirement planning, providing benefits such as tax-free growth, tax-free withdrawals and no required minimum distributions. However, it’s important to carefully consider the immediate tax implications. By weighing the benefits, drawbacks, and strategic considerations, you can make an informed decision that aligns with your financial situation and retirement goals.