Build a Tax-free Income Stream: Consider a IRA Roth Conversion

What is a Roth conversion

A Roth conversion refers to taking all or part of the balance of an existing traditional IRA and moving it into a Roth IRA.

Why you might convert a Traditional IRA to a Roth IRA

Enjoy tax-free withdrawals in retirement

When taking withdrawals from a traditional IRA, you'd have to pay taxes on the money your investments earned—and on any contributions you originally deducted on your taxes. With a Roth IRA, as long as you meet certain requirements, all of your withdrawals are tax-free.

Watch your money grow tax-free for longer

Traditional IRAs force you to take required minimum distributions (RMDs) every year after you reach age 73*, regardless of whether you actually need the money. So you lose the tax-free growth on the money you had to withdraw.

On the other hand, Roth IRAs don't have RMDs during your lifetime, so your money can stay in the account and keep growing tax-free.*

* Due to changes to federal law that took effect on January 1, 2023, the age at which you must begin taking RMDs differs depending on when you were born. If you reached age 72 on or before December 31, 2022, you were already required to take your RMD and must continue satisfying that requirement.  However, if you had not yet reached age 72 by December 31, 2022, you must take your first RMD from your traditional IRA by April 1 of the year after you reached age 73.

Leave a tax-free inheritance to your heirs

The people who inherit your Roth IRA will have to take RMDs, but they won't have to pay any federal income tax on their withdrawals as long as the account's been open for at least 5 years.

A conversion can get you into a Roth IRA—even if your income is too high

The conversion would be part of a 2-step process, often referred to as a "backdoor" strategy.

First, make your contribution to a traditional IRA—which has no income limits. Then, transfer the funds into a Roth IRA using a Roth conversion. Make sure you understand the tax consequences before using this strategy.

Other questions to consider

Will you need the money in 5 years or less?

There's a 5-year holding period on withdrawals of money that were part of a Roth conversion. So if you think you'll need the money within that time, you could end up owing the taxes you were hoping to minimize with a conversion. 

Will you end up in a higher tax bracket?

All or a portion of the money you convert could be considered "reportable income" by the IRS. If you're on the cusp of the next tax bracket, there's a chance you'll get bumped up in the year you convert.

To avoid this, consider converting a portion of your traditional IRA. This could help you:

1. Stay out of that higher tax bracket.
2. Spread the taxes related to the conversion over a few years instead of getting hit with the entire bill in 1 year.

Will your tax bracket be higher now or later?

No one really knows how tax rates could change over the next 5, 15, or 25 years.  But, considering the growing government deficit, it's likely tax rates will be higher.

If you believe your tax rate is lower now than it will be when you start taking withdrawals, a conversion may look promising because you'll pay conversion taxes while you're in a lower tax bracket and enjoy tax-free Roth IRA withdrawals later (when the higher tax bracket won't matter).

But if you believe your tax rate is higher now than it will be when you start taking withdrawals, a conversion could cost you more in taxes now than you'd save with tax-free withdrawals later.

So what do you do? It may help to "diversify" your taxes—in other words, pay some of the taxes now (when you're still building your retirement savings) and save some for later (when you need that money to cover expenses in retirement).

Give this some thought and talk with your tax advisor about what might be best for you.

Where will you get the money to pay the conversion taxes?

Before you use money from your IRA to pay the tax bill, consider the following:

Short-term consequences

The money taken out of your IRA to pay conversion taxes would be considered a distribution. This could result in even higher taxes in the year you convert.

In addition, if you're younger than age 59½ and you withdraw money from your IRA to pay conversion-related taxes, you could also face a 10% federal penalty on that withdrawal.

Long-term consequences

You'll lose the chance for that money to compound and grow tax-free in your IRA—which means less money when you need it in retirement.

Deciding whether to convert to a Roth IRA hinges on issues like your tax rate now versus later, the tax bill you'll have to pay to convert, and your future plans for your estate. And remember, the conversion will be permanent—you can't revert the money back to a traditional IRA.

At Claro Advisors, we can help illustrate the ramifications of implementing a Roth Conversion to help determine if it's the right strategy for you.