Is Now a Good Time to Do a Roth Conversion?

You’re probably tired of hearing it, but it bears saying again – 2020 has been an unprecedented year. In the current financial climate, when markets are down and unemployment is on the rise, it might be a good time to do a Roth conversion, which means moving some of your retirement savings from a traditional Individual Retirement Account (IRA) into a Roth IRA.

The Roth IRA differs from a traditional IRA in a few key ways and it’s possible that converting some of your retirement savings into a Roth IRA could reduce your tax bill in the future, when you withdraw your Roth funds in retirement. Of course, only a qualified tax advisor can help to assess your situation and recommend the best approach. If you want to learn more about Roth IRAs and why now might be a good time for a Roth conversion, here’s a quick guide:

Roth IRAs vs. Traditional IRAs

To understand if a Roth conversion is the right step, you’ll need to know the differences between Roth accounts and traditional retirement accounts.

The traditional IRA, which stands for individual retirement account, lets you save money for retirement in a way that’s tax-advantaged. An IRA can hold a range of financial products – not only cash-based savings, but also stocks, mutual funds, EFTs and bonds. The advantage of putting your money into an IRA rather than a normal savings account is that contributions are tax-deductible. In other words, if you put $2,000 into your traditional IRA, that’s $2,000 that won’t be counted by the IRS as taxable income. However, when you begin to withdraw money from a traditional IRA after retirement, you’ll need to pay taxes just as you would with normal income earnings.

A Roth IRA, on the other hand, requires that initial contributions come from income that’s already been taxed. In other words, there’s no immediate tax advantage to the account – however, when you retire, the money you withdraw from your Roth IRA won’t incur any income taxes. The Roth IRA also differs from a traditional IRA in not requiring you to take minimum distributions at age 72, which can be useful if you’d prefer to let funds stay in the account and continue to grow.

What’s a Roth Conversion?

A Roth conversion means rolling over funds from your traditional IRA into a Roth IRA. Performing a conversion means you’ll need to pay income taxes on the funds withdrawn for the year the funds were withdrawn, just as you would if you were taking out money from a traditional IRA at some other point in the future.

Potential Benefits of Roth Conversion

Why convert from a traditional IRA to a Roth IRA, if it means paying more taxes in the short term? There are a few reasons why some people might do a conversion.

Firstly, Roth IRAs don’t have required minimum distributions (RMDs), so if you don’t anticipate needing liquid funds to be withdrawn each year after age 72, it can be advantageous to let your retirement savings continue to grow tax-free in a Roth account.

Another benefit to performing a conversion is to reduce the tax burden on your heirs. While people who inherit funds in a Roth IRA are required to take out the RMDs, they won’t need to pay federal income taxes on these withdrawals; assuming the account has been opened for a minimum of five years.

Converting your funds to a Roth IRA could also be a wise move if you currently find yourself in a low tax bracket, and expect to be in a higher tax bracket later on. Because the taxation rules on a Roth IRA are opposite to a traditional IRA, it’s most beneficial to put funds into the account when you’re paying less income tax, so that you can enjoy tax-free withdrawals later on when your income bracket may be higher.

Is Now a Good Time to Convert?

You may have experienced an impact to your personal income as a result of the pandemic. If you have a lower marginal income rate for 2020 than you have in previous years, that could mean a lower tax bill if you choose to convert to a Roth IRA before your income situation changes again.

Diversifying Your Retirement Savings

Instead of rolling over funds from a traditional IRA to a Roth account, another option may be to open a Roth account for the first time, assuming you don’t currently hold one. Holding both types of retirement account can be a good way to diversify your retirement savings to enjoy the advantages of each.

Final Thoughts

Before making a final decision, schedule a thorough consultation with a tax and retirement professional. They can walk you through the various scenarios and options, and help you to determine which retirement strategy is best for your unique situation.