What is a Roth IRA?
A Roth IRA is a tax-efficient way to help you save money for your retirement. It is an individual retirement account that is funded with after-tax dollars. The contributions are not tax-deductible. Although you do not receive a tax benefit upfront the account allows you to take qualified withdrawals on a tax-free basis as long as certain conditions are satisfied.
Some of the qualified conditions include having the account open for five years, being 59 ½ or older, being disabled, using the funds for qualified education expenses, or for a first-time home buying experience.
Benefits of a Roth IRA
The biggest benefit of a Roth IRA is the tax-free withdrawals. Future tax brackets are unknown which is why having a Roth IRA is beneficial. If your taxes are higher in retirement than they are right now you will not need to worry about paying taxes on your Roth IRA withdrawals. Not having to stress about paying taxes on your qualified distributions makes planning for your retirement much more simple.
A Traditional IRA requires you to take Required Minimum Distributions (RMDs) whereas a Roth IRA does not require RMDs. This allows you to have more financial freedom since you can decide when to take your qualified distributions.
Aside from being used as a retirement account, a Roth IRA is very flexible. Contributions to a Roth IRA can be distributed at any time and used as an emergency fund. They can also be used to pay for qualified education expenses or a first time home purchase.
What is a Roth Conversion?
A Roth conversion is a transfer tactic used to move retirement assets from a Traditional, SEP, or SIMPLE IRA over to a Roth IRA. This results in a taxable event but it can be beneficial in the long run. Individuals who have large Traditional IRAs who expect to pay higher taxes in the future will be able to take tax-free qualified distributions once a Roth conversion is complete.
Since the Traditional, SEP, or SIMPLE IRA is funded with pre-tax dollars and a Roth IRA is funded with after-tax dollars, you must pay taxes on the converted funds. Once these taxes are paid the Roth IRA will never have to pay taxes again as long as the withdrawals taken are qualified distributions.
“Filling the Tax Bracket Bucket” Roth Conversion Strategy
A Roth conversion requires taxes to be paid on the money being transferred over to the Roth IRA. This triggers an increase in an individual or couple’s taxable income for the year the Roth conversion takes place. If a Roth conversion occurs for a large account with hundreds of thousands of dollars in it this can cause an individual to jump into a higher tax bracket. While a Roth conversion is supposed to help ease the pain of taxes this can be a self-defeating move if the individual is pushed into a higher tax bracket.
To avoid getting hit with higher tax rates an individual or couple can limit the amount they convert. For example, if a couple has taxable income of $70,000 and a $500,000 IRA that they want to convert to a Roth IRA they can make conversions each year rather than all at once. They are currently in the 12% tax bracket so in order to make a Roth conversion that keeps them in the 12% bracket they can make a Roth conversion of up to $10,250 for the 2020 tax year. This will not bump them up into a higher tax bracket, which would have resulted in them owing more taxes. They can do this each year until the Traditional IRA is fully converted to a Roth IRA. Choosing to do a Roth conversion by optimizing the tax bracket bucket strategy the couple is able to experience the favorable tax benefits of a Roth IRA without facing a huge tax liability in 2020.
Interested in creating a Roth IRA or learning more about Roth conversions? Schedule a complimentary consultation with us.
Episode 52 – How to Live the Retirement of Your Dreams With Fritz Gilbert of The Retirement Manifesto