Optimize Your Tax Strategy with Roth IRA Conversions

By Devon Walsh

Roth IRAs and Traditional IRAs-  What are the Differences? 

With a Traditional IRA, you can contribute pre-tax money. Your savings grow over time, but when you take the money out in retirement, you’ll pay taxes on those withdrawals. A Roth IRA, on the other hand, is the opposite—you contribute money that’s already been taxed, so while you don’t get a tax break upfront, your money grows tax-free, and you won’t owe taxes when you withdraw it later. Plus, with a Roth IRA, there’s no requirement to start taking money out at a certain age, giving your savings more time to grow.

Picture This: You’ve just turned 73 and are now required to start taking Required Minimum Distributions (RMDs) from your Traditional (tax-deferred) retirement accounts. While it might seem great to have extra income, you realize that you don’t need the RMD because you already receive Social Security, a pension, and income from taxable accounts. So, you park the RMD in an investment account—but here’s the catch: even though you don’t spend it, receiving the distribution is still a taxable event.

Wouldn’t it be great if you didn’t have to trigger that taxable event at all? That’s one of the many benefits of converting your Traditional IRA assets into Roth assets through a Roth IRA conversion. 

What Is a Roth Conversion?

Simply put, a Roth conversion involves paying taxes on your tax-deferred assets now and moving them into a Roth IRA. While no one loves paying taxes upfront, consider this: your non-Roth tax-deferred retirement assets will continue to grow, potentially increasing your future tax liability if tax rates stay the same or rise.

Once converted, your Roth IRA grows tax-free, and withdrawals are non-taxable. Conversions can be done partially or fully, with no annual limits or claw-backs to worry about. They can also be done with select 401(k)s and 403(b)s; however, I will be sticking to Traditional IRAs for the purposes of this article. 

When do Roth Conversions Make Sense?

You Plan to Save, not Spend, Your RMDs

Unlike Traditional IRAs, Roth IRAs don’t require you to take RMDs. This gives you full control over when and how much you withdraw, allowing your assets to grow tax-free over the long term. If you don’t need to spend your RMDs to live comfortably and intend to save them, a Roth conversion might be for you.

Managing Estate Taxes (VT Estate Tax Exemption) 

If your taxable estate is close to or over Vermont’s $5 million estate tax exemption and consists primarily of tax-deferred assets, converting to a Roth can help reduce the taxable value of your estate. 

A Trust is Named as the Primary Beneficiary  of your Traditional IRA 

Jennifer Rowe wrote an article in our April 2021 newsletter, which is archived on our website, discussing the impact of leaving tax deferred assets in a trust. To summarize: if income from a Traditional (non-Roth) IRA is trapped in the trust and is not distributed out to the beneficiary, income above $15,650 will be taxed at 37% (the top trust tax bracket). While provisions can be added to shift the responsibility to pay tax from the trust itself to the beneficiary, that doesn’t work well if you want the beneficiary to receive only a portion of the income that the trust generates. A Roth IRA avoids these complications because it generates no taxable income when distributions into a trust occur. 

For the Benefit of Your Heirs 

Non-spousal beneficiaries of a Traditional IRA will have to take RMDs from inherited IRA assets, and this will add to their earned income if they are still working, potentially pushing them into higher tax brackets. However, inheriting Roth IRA assets means your heirs will not be paying any income taxes on distributions from the Roth. Instead of needing to take required minimum distributions annually for 10 years, your heirs will not be required to withdraw from the Roth IRA until the 10th year after it is inherited. This allows the retirement account to grow tax-free for another 10 years after your death, to the increased benefit of your heirs. 

Items to Consider Before Converting: 

1 Immediate Tax Bill: Converting means you’ll owe taxes on the converted amount in the year of the conversion, which might bump you into a higher tax bracket, and you’ll need to have funds available to cover those taxes. 

2 Impact on Financial Aid and Benefits: The extra income could affect things like financial aid eligibility, Medicare premiums, and other income-sensitized benefits. 

3 Market Timing Risks: If you convert when the market is trading at a high valuation, you might pay taxes on peak values, with the risk that markets could dip afterward. In the short term this could leave you feeling like you made a mistake. 

Is a Roth IRA Conversion Right for You? 

A Roth IRA conversion isn’t a one-size-fits-all solution, but it can be a game-changer for your retirement strategy. It all comes down to your current and future tax situation, retirement dreams, and financial needs. After all, your retirement should be as stress-free and rewarding as possible. If you are interested and want to learn more, please feel free to reach out to us!