Updated: Oct 27
It's summer time and you know what that means, it's time for road trips, sitting by the pool and staying close to the A/C. During the middle of the year most people aren't thinking about Roth IRAs and Taxes, thoughts about 1040s and the IRS are miles & months away. Taxes may not be the first thing on everyone's mind but right now we are in the middle of a golden opportunity. Right now, July of 2022, is the perfect time to convert amounts from your traditional IRA & 401Ks to a Roth.
Most people I speak with need a quick refresher on the difference between traditional and Roth retirement accounts when saving for retirement is brought up so let's take a moment to make this distinction. Generally speaking, there are two main types of IRA accounts. A traditional account where contributions are "deferred" from income. Money put into a traditional IRA is eligible for a deduction for tax purposes (income limitations apply) and is taxed later in retirement when it's withdrawn. A Roth is, in a way, the opposite. Contributions to a Roth IRA are not eligible for a deduction BUT are nontaxable when withdrawn during retirement. To make things simple, traditional is free now, tax later. A Roth is tax now, free later.
Is It Better to Have Money in a Roth or traditional IRA?
The first question is it even worth doing a Roth conversion in the first place? The answer really depends on how you look at things. At the end of the day, putting money away for retirement will always be better than not. While contributing to a traditional IRA has it's immediate benefit up front, the perks stop there. If you are willing to forgo the immediate benefits and play the long game by contributing to a Roth IRA, there are many benefits that await you on the other side of retirement.
Tax brackets are also an important item to consider when deciding between contributing to a traditional or Roth IRA. As I write this article, we are in lower tax tax rates due to the Tax Cuts and Jobs Act enacted by the Trump administration in 2017. These current low rates are temporary however with most provisions expiring in 2025 unless extended by congress. Lower tax rates translates into lower taxes compared to the same transaction in times of higher rates. This opens up an area for tax planning in itself, no one know what the future holds but it seems unlikely that taxes could go lower in the faceable future given the current environment we find ourselves in post COVID.
What is a Roth conversion?
A Roth conversion is the process of transferring or reclassifying amounts held in a traditional IRA or other accounts such as a 401(k) to a Roth IRA. Typically this is done with amounts that have previously been tax deferred. Amounts that were previously tax deferred are reported as ordinary income in the year of the conversion. In other words, if you held $10,000 in a traditional IRA and converted these funds to a Roth, you would report $10,000 as income when filing your taxes.
While a conversion usually results in an increase in taxable income. It doesn't necessarily mean you have an increase in taxes. Business owners can take advantage of down years in their business by doing a Roth conversion. Years where no income is earned is also a great time to do conversion. For example, you were unable to work due to illness, it's possible to avoid taxes completely by converting amounts under the standard deduction. These are just a few way you can take advantage of an unfortunate situation and avoid taxes now and down the road in retirement.
Why is Now a Good Time For a Roth Conversion?
If your retirement account currently looks anything like mine, there are red and negative numbers down the board. Simply put, it's a rough time in the stock market these days. At the time of this article, the S&P 500 is down by 15% Year-to-Date. That's a bummer for for sure, but it doesn't have to be all bad. If you were to con
vert the same shares today as last year, you are essentially getting a 15% break on the taxes. Let's say you transferred 10 shares valued at $10 each last year you would owe taxes on $100 of income. If those same shares are now worth $8, you only owe tax on $80 of income. Presumably, those same shares will recover and grow but now are now tax free in retirement. This tactic is especially powerful if you have the funds to cover the taxes on the conversion to avoid funds being withheld at time of conversion to cover taxes.
Right now could be a historically good time to convert funds to a Roth from traditional accounts. It's a perfect storm of low tax rates, a dip in the stock market and favorable tax laws for retirement accounts. A bit of tax planning today can save you literally thousands of dollars just by moving funds from one account to another. This is the power of tax planning and thinking strategically with your finances.
As always, I highly recommend speaking with a seasoned tax professional before making any moves with your finances. Success from Roth conversions will vary from person to person so it's in your best interest to consult the advice from a professional.
This is not intended to be financial advice. Seek the advice of a tax professional before moving funds. Investing involves risk. This is not a recommendation to buy or sell any stock or financial security.