There are many aspects of the United States tax code that are confusing and even conflicting. For example, gift taxes cause consternation amongst taxpayers, as those tax code sections are challenging to interpret. Another source of puzzlement is the venerable IRA. What should be a simple “put money away” account is anything but simple. There are many rules and regulations around IRAs, including maximum earnings for contributions and tax deductibility. There are also two types of IRAs: Roth and traditional.
Most people open one of the IRA types (Roth or traditional) and deposit money, gaining any tax deductions or other benefits from that one account. However, there are some scenarios when you would want to convert a traditional IRA to a Roth account. To understand when this conversion might make sense, let’s first recap the features of traditional and Roth IRAs.
Traditional and Roth IRAs: What’s the Difference?
The intent behind a traditional IRA is that you contribute pre-tax dollars, have them grow tax-deferred, and pay taxes on your withdrawals later. A traditional IRA is a tax-deferred retirement vehicle, meaning that you are deferring paying taxes on your employment income and investment income until you retire.
By contrast, a Roth IRA lets you put after-tax money into your account. That money grows (dividends, interest, stock appreciation, etc.), and when you withdraw, all the money you have is tax-free. So you pay taxes on your income right now, and any earnings in your Roth IRA are not subject to any future tax.
Importantly, ROTH IRAs don’t have Required Minimum Distributions. You can withdraw your contributions (not earnings) any time tax and penalty-free since you already paid tax at the time of contribution. With a traditional IRA, you have required distributions starting at age 72, and you will pay penalties and tax on any withdrawals before age 59.5. While you typically should never break into your retirement nest egg, Roth IRAs do offer more flexibility in an ‘emergency’.
Friendly side note: Most situations can be budgeted for and aren’t actually emergencies. The urgency and worry comes from not being prepared.
Should You Choose a Traditional IRA or a Roth IRA?
There are many schools of thought as to which is better for which circumstance. Generally, your income decreases during retirement (which is the case for most people), so you want to contribute to a traditional IRA to lower your taxable income now and pay the lower tax during retirement. For people who expect their tax rates to go up, the Roth IRA makes more sense.
Therefore, conceptually, a Roth IRA is better for lower-income earners, and a traditional one is better for higher-income folks. But there’s a catch. Suppose you have access to another retirement plan through your work (e.g., a 401(k)). In that case, you can only receive the full tax deduction for a traditional IRA if your adjusted gross income (AGI) is below a certain threshold. For married couples, the deduction phases out starting at $104,000. For a single person, that threshold is $65,000.
A high-income household wouldn’t get any tax deduction on the money contributed to a traditional IRA. If they put in $6,000, they’ll pay tax on that money now, and pay tax on the gain when they withdraw it at retirement! That’s not good at all.
At this point, you might be thinking that a high-income household could use a Roth IRA! However, those have contribution limits as well. Single people who have adjusted gross incomes above $139,000 and married couples with incomes exceeding $206,000 cannot contribute to a Roth IRA at all.
Therefore, a single person with an (AGI) above $65,000 loses the tax deduction benefits of a traditional IRA and loses the ability to contribute to a Roth IRA altogether above $139,000.
Sometimes it feels like the IRS doesn’t make saving easy!
You Can Convert From a Traditional IRA To a Roth Account
If you contribute to a traditional IRA, you can convert it to a Roth IRA by paying the taxes on that money. The amount you convert gets taxed as ordinary income. As a quick example, if you earned $100,000, and you converted $20,000 from a traditional IRA to a Roth one, you’d add that $20k to your overall income, and your tax bill would be as if you earned $120k that year. The advantage is that anything converted into the Roth IRA continues to grow tax-free and is tax-free on withdrawal.
There are four scenarios when this conversion can make lots of sense.
The first is what’s known as the “backdoor Roth.” Recall that there were income limits for people contributing to a Roth IRA. There are none for traditional IRAs. Therefore, someone earning above the Roth IRA limits can contribute to a traditional IRA and immediately do a conversion to a Roth account. They’ll pay the taxes on those earnings, but this technique bypasses the Roth IRA contribution limits altogether.
Another scenario is when you want to avoid the required minimum distributions at 72. Let’s say that you have plenty of money, and you don’t want the IRS forcing you to withdraw your retirement savings at 72 because you won’t need the income. If that’s the case, you may want to convert some traditional funds (401(k)/457(b)/401(k) included) because Roth IRAs have no minimum distributions.
Although less common, people may convert their IRAs because they expect to be in a higher tax bracket in retirement. One scenario is if you’ve been contributing to a traditional IRA and find yourself taking a year or two off work. You might convert some of your traditional funds during those low-tax years since you won’t be in a lower tax bracket during retirement.
Finally, if you want to lower your taxable income during retirement, a conversion might make sense. Since Roth withdrawals are not taxable income, they won’t make your Social Security income taxable. You can withdraw $100,000, for example, from your Roth IRA and pay $0 in taxes on your Social Security income. If that comes from a traditional IRA, you’ll most likely pay taxes on it all.
Having a Retirement Strategy Is Essential
The legal complexities of Roth and traditional IRAs make it essential to have a cohesive retirement strategy. Envision your career and retirement early on to chart a comprehensive path forward. There are a few scenarios where you’ll want to convert a traditional IRA to a Roth account, but those conversions are often costly upfront. You may miss a crucial element that ends up negating the benefits or costing you even more in the long run.
Before you make any significant financial moves, it’s often best to speak with a tax professional or accountant to ensure that your actions have the impact on your retirement for which you’re hoping!