Roth Conversion: Evaluating If It Aligns with Your Financial Goals

Picture of Annrose Isaac CPA, CFP®, MBA
Annrose Isaac CPA, CFP®, MBA

In the ever-changing realm of personal finance, people are continually searching for new and creative ways to enhance their retirement plans while reducing their tax obligations. One such strategy that has garnered increased attention in recent years is the Roth conversion. This financial tactic permits individuals to transform a portion or all of their pre-tax retirement savings into Roth assets, potentially yielding substantial tax advantages over time. If you’re looking for new ways to boost your retirement savings, read on for an exploration into factors that you should keep in mind when determining if a Roth conversion properly aligns with your financial goals.

Understanding the Roth Conversion Process

Before diving into the evaluation process, it’s essential to grasp the basics of a Roth conversion. A Roth conversion involves moving assets from a traditional IRA or 401(k) into a Roth IRA. In a traditional IRA or 401(k), contributions are typically tax-deductible, and the funds grow tax deferred but withdrawals from the accounts are typically considered taxable income. Conversely, Roth IRAs are funded with after-tax contributions, the funds grow tax-deferred but any qualified withdrawals in the future, including earnings, are generally tax-free.  There is an advantage to converting pre-tax IRA or 401(k) funds to ROTH IRAs in order to create a bucket of retirement funds that can be withdrawn tax-free in the future.  Prior to engaging in a ROTH conversion though it is very important to model the immediate tax impact of the planned ROTH conversion because the conversion itself requires taking a taxable withdrawal from the IRA or 401(k), and depositing those funds into a ROTH IRA.

Evaluating Your Financial Goals

Here are some of the aspects of your finances you’ll want to consider in order to determine whether a Roth conversion makes sense for you in any particular year:

Tax Bracket Considerations

One of the primary factors to assess when contemplating a Roth conversion is your current and expected tax brackets. The key idea here is to determine whether you would benefit from paying taxes on the converted amount now at your current tax rate, or if it would be better to wait to pay taxes in retirement, which could be at a potentially higher rate.  While many people assume that they will be in a lower income tax bracket during their retirement years, it isn’t always the case.  Pension, Social Security, investment income as well as mandatory Required Minimum Distributions (RMDs) from retirement accounts have the potential to continue to keep even retirees in higher income tax brackets.


SEE ALSO: The Importance of Tax Planning in Your Financial Plan

If you expect to be in a lower tax bracket during retirement, it might make more sense to delay your Roth conversion and continue contributing to your traditional IRA or 401(k). However, if you anticipate being in a higher tax bracket in retirement, then chances are a Roth conversion would be advantageous.

Current Financial Situation

When you convert a traditional IRA or 401(k) into a Roth IRA, you’re required to pay taxes on the converted amount in the year of the conversion. Because of this, it’s vital to assess whether you have the financial means to cover these taxes without dipping into the retirement savings being converted. If you want to maximize the benefits of the conversion, then you’re going to want to be paying your taxes from non-retirement accounts.

Impact on Medicare Premiums

Taking a distribution from an IRA or 401(k) in order to convert the funds into a ROTH IRA generates taxable income.  Since premiums for Medicare Part B and Part D coverage are affected by a Medicare recipient’s Modified Adjusted Gross Income as reported on their tax return, the presence of this additional income has the potential to push a Medicare recipient into higher Medicare premium tiers.  Consequently, Roth conversions for Medicare recipients also need to consider the impact on Medicare premiums.

Liquidity Needs

As you’re contemplating a Roth conversion, be sure to assess your short-term and long-term liquidity needs. Any money converted to a Roth IRA is generally not available penalty-free for five years, making it less suitable for emergency funds or immediate financial needs. So, you’ll want to ensure you have sufficient liquid assets outside of your retirement accounts to cover short-term expenses.

Estate Planning Goals

If you have significant assets and intend to leave a financial legacy, a Roth conversion can play a crucial role in your estate planning. Unlike traditional IRAs, Roth IRAs do not have required minimum distributions (RMDs) during your lifetime, which allows the funds to continue growing tax-free.  Your beneficiaries who inherit your ROTH IRA are subject to Required Minimum Distribution rules but the RMDs that they receive will generally be tax-free unless the ROTH account is less than 5 years old at the time of withdrawal.


SEE ALSO: Tips for Creating a Multigenerational Estate Plan

Impact on Other Financial Goals

Lastly, consider how a Roth conversion aligns with your broader financial objectives. For instance, if you plan to purchase a home, pay for your child’s education, or start a business in the near future, a large Roth conversion might not be the best choice, as it could result in a substantial tax liability. You want to be sure that you’re balancing your short-term and long-term financial goals to determine the appropriate timing and size of any conversions.

Is a Roth Conversion the Right Move for You?

Ultimately, evaluating whether a Roth conversion aligns with your financial goals is a multifaceted process. As you’re considering, it’s important to remember that the decision should align with your broader financial objectives. To ensure that you’re making the best choice for your financial situation, it may be beneficial to work with a financial advisor who can provide you with personalized guidance based on your unique circumstances. By carefully evaluating these factors, you can make an informed choice that helps you achieve your long-term financial goals while minimizing tax liabilities.

If you think that a Roth conversion could optimize your retirement strategy or feel as if your plans could benefit from the guidance of a professional, contact us today. Our team of advisors is ready to provide you with personalized guidance and expert insights tailored to your short- and long-term financial goals.

This communication contains the opinions of Wade Financial Advisory, Inc. about the securities, investments and/or economic subjects discussed as of the date set forth herein. This communication is intended for information purposes only and does not recommend or solicit the purchase or sale of specific securities or investment services. Readers should not infer or assume that any securities, sectors or markets described were or will be profitable or are appropriate to meet the objectives, situation or needs of a particular individual or family, as the implementation of any financial strategy should only be made after consultation with your attorney, tax advisor and investment advisor. All material presented is compiled from sources believed to be reliable, but accuracy or completeness cannot be guaranteed. PAST PERFORMANCE DOES NOT GUARANTEE FUTURE RESULTS. INVESTMENTS BEAR RISK INCLUDING THE POSSIBLE LOSS OF INVESTED PRINCIPAL.

Wade Financial Advisory, Inc. is an investment adviser registered with the Securities and Exchange Commission. Registration of an Investment Advisor does not imply any level of skill or training. A copy of current Form ADV Part 2A is available upon request or at www.advisorinfo.sec.gov. Please contact Wade Financial Advisory, Inc. at (408) 369-7399 with any questions.

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