Maximize Your Savings in Retirement Planning: Why You Should Consider Converting Your IRA to a Roth IRA

Contributing to a Roth IRA can be a good way to save for retirement and diversify your taxes. 

Funding a Roth IRA to a substantial amount can be tricky, though, since investors have a $6,000 maximum on contributions in both 2019 and 2020. (People over age 50 can contribute an additional $1,000.) 

 One work-around is to convert your traditional IRA into a Roth IRA.

Most people end up with more tax-deferred money inside a 401(k) or other employer-sponsored retirement account, which allows for higher annual contributions. Eventually, many people roll their 401(k)s into IRAs to continue the tax-deferred nature of the savings and investments. Converting a traditional IRA – which tend to have more money in them than Roth IRAs – into a Roth IRA can be a powerful tool to boost your retirement planning.

Why does converting a traditional IRA to a Roth IRA make so much sense? How would you benefit?

1)  Enjoy low tax rates today 

Typically, the biggest catalyst for Roth conversions is tax planning. Traditional IRA money is deductible when you put money in and taxable when money comes out. With Roth IRAs, money is taxed now, but investments grow tax-free, therefore distributions are tax-free (assuming you meet certain holding period and trigger events).

The decision to roll over money from traditional to Roth boils down to one thing: Do you think tax rates will be higher for you today or in the future when you take out distributions in retirement?

With the Tax Cuts and Jobs Act in effect today, many Americans are in lower tax rates than before. If you’re in a low tax rate in 2019, consider converting money to a Roth IRA.

2)  Have control over your money

One big difference between IRAs and Roth IRAs is that traditional IRAs are subject to required minimum distributions (RMDs) when you turn 70.5, while Roth IRAs aren’t. By converting money from a traditional to a Roth IRA, you give yourself more control over your money. You can spend it when you want, as opposed to when the government tells you to take distributions.

3)  Maintain Social Security and Medicare costs

The distribution or RMD you take from a traditional IRA are typically taxable – which can raise your taxable income, push you to a higher tax rate, increase your Medicare costs and reduce the amount you get to keep from Social Security.

 Social Security benefits are potentially taxable based on something called provisional income. Up to 85% of Social Security benefits can be subject to taxes. Additionally, Medicare premiums are subject to something called IMRAA surcharges that can drive up your Medicare premiums by thousands of dollars a year.

However, qualified Roth distributions in retirement are non-taxable – you can take out money from a Roth IRA to meet retirement needs without driving up taxes on Social Security benefits or increasing Medicare premiums.

Now you know why you might want to roll a traditional IRA into a Roth IRA. It’s important that you also make sure you understand the dates and tax implications of rolling over from a traditional to a Roth so you can maximize the benefits Roth conversions brings in retirement planning. Keep these things in mind:

Any untaxed amounts rolled over or transferred to a Roth IRA are subject to income taxation. To convert money to an IRA and have the taxable income included in a given year, the conversion must take place by Dec. 31.

 For example, let’s say you decide to convert $20,000 from your IRA to your Roth IRA this year. You just increased your taxable income by $20,000 – assuming your entire IRA was pre-tax money – and the conversion amount would be subject to your current income tax rates.

 If you are married, filing jointly and had taxable income of $100,000, you would have a taxable income of $120,000 after the conversion. You’d stay in the 22% tax rate in 2019 and would owe $4,400 in federal income tax (22% of $20,000). You could use your conversion to pay the taxes, but it’s typically better to pay them from an outside account, so you get the full $20,000 rolled over to the Roth IRA. 

Retirement planning is complex. You have to balance savings and spending while working through tax situations that could reduce your Social Security benefits or increase your Medicare costs. Roth conversions are a tax and financial planning tool that – when used correctly and as part of a retirement income plan – can help provide financial flexibility and freedom through tax diversification and increased control.