Bob French, CFA

How a Roth Conversion Could Save You Money in the Long-Term

Roth conversions are in that category of financial concepts that sound more complicated than they actually are. The basic idea is that you take money from your traditional IRA, withdraw it, pay taxes on it, and move it to your Roth IRA. In other words, you take some money from a tax-deferred account, pay taxes on it, and then put it in a tax-exempt account.

This means you will be paying more in taxes today. Why would you want to do that? Well, there are a whole bunch of reasons, but they almost all come down to reducing your taxes in the long term. “Typically, Roth conversions are performed in a year when you have income that is lower than normal, and, most important, lower than you expect in retirement.”

In addition to the tax advantage, Roth conversions can also help you manage your required minimum distributions in retirement. The IRS wants to be able to get at your retirement accounts, so once you hit 70½, you need to start taking money out of some (but not all) of your retirement accounts. (For a refresher, take a look at our article on RMDs.)

One of the accounts that you will need to take an RMD from is your traditional IRA. By reducing the amount of money in your IRA, you also reduce the amount you will be required to withdraw from the account on an annual basis. This gives you more financial flexibility in retirement.

These are the three main ways you can position yourself to do a Roth conversion:

  • Manage Your Income Through Time – For those folks who have the ability to control the timing of your income, you can advance or defer your income to create years with lower than normal income.
  • Charitable Giving – If you group contributions together, you can drastically reduce your taxable income in a given year. You may want to think about a donor-advised fund if you are going down this road. A donor-advised Fund will allow you to make a large (tax deductible) donation in one year and then distribute it over time.
  • Early Retirement – The period right after you retire and before you start receiving Social Security is often a great opportunity to do Roth conversions. For many people, this will be the least amount of taxable income they will have had in decades. You no longer have much if any income from working, you aren’t getting income from Social Security, and you’re living off your taxable portfolio, so you aren’t drawing from your retirement accounts. Depending on your specific situation, this might be your best opportunity to do a Roth conversion.

Roth conversions are very powerful tools for managing your finances in retirement, but there is a lot to consider before you decide to do one. You need to think about your tax situation today versus your taxes and flexibility in the future.

You need to think about how to position yourself to generate and take advantage of a Roth conversion opportunity. Not to mention, the logistics of the conversion can be quite complicated for such a simple process.

It’s a good idea to discuss your situation with a financial advisor to figure out if a Roth conversion makes sense.

Next, read our eBook 12 Principles of Intelligent Investors.

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