Americans are utilizing the retirement savings features of IRAs more than ever. However, Roth IRAs are still underutilized, due in part to a misunderstanding of how the vehicle can be strategically used for retirement planning.
While you can make annual after-tax contributions to a Roth IRA if you meet a certain income threshold, it is not the only way to get money into a Roth IRA.
One underutilized feature is the
Roth IRA conversion, which can provide a variety of benefits such as reduced risk of rising taxes and the ability to better control taxes on Social Security benefits and Medicare premiums, all of which can lead to more retirement security. The one benefit that most don't appreciate is that paying taxes on the conversion is equivalent to making contributions to a tax-advantaged retirement plan.
Let's take a look how Roth conversions work and when they can be an effective tool to supercharge your retirement savings.
TAX-FREE GROWTH
First, when an IRA or 401(k) is converted into a Roth IRA, the participant pays taxes on the value of the taxable portion of the account on the date of the conversion. This increase in current taxes scares a lot of people away, including accountants, who often think in terms of deferring taxes as long as possible.
So why would you want to increase your taxes today by engaging in a Roth conversion? Growth in the account after the conversion will be tax-free as long as certain qualification requirements are satisfied. Also, unlike traditional IRAs, Roth IRAs are not subject to required minimum distributions at 70½.
The real issue, however, is that few people have good tax diversification of their retirement accounts, as most retirement savings are in tax-deferred accounts like 401(k)s and IRAs. In these accounts, the government essentially owns a portion of your savings, and you will pay ordinary income taxes on withdrawals.
Additionally, with the current tax-rate environment, most professionals believe tax rates will continue to increase for a number of years. This means you could end up being in a higher tax bracket in retirement than you are today, making it better to do a Roth conversion now and pay lower taxes today. However, even a partial conversion can help you diversify the taxation of your accounts, lowering the risk of changing tax rates.
INCREASED CONTRIBUTIONS
Even with all of these benefits, many choose not to take advantage of Roth conversions. Maybe the better way to look at the Roth conversion is that it is an indirect way to increase contributions to a tax-advantaged savings vehicle for retirement — circumventing the maximum contribution limits that otherwise apply.
Let's look at an example. Susan has worked for decades and has saved up $200,000 in her 401(k), $200,000 in a deductible IRA and $250,000 in the bank. Susan decides that she wants to get more of her personal savings into a tax-advantaged savings vehicle. At age 65, she can only contribute either $6,500 a year as a deductible IRA contribution or a Roth contribution.
Instead, Susan decides that over the next two years she will convert the $200,000 IRA to a Roth IRA. In the first year she converts $100,000, increasing her taxable income that year by $100,000. She decides to pay her 35% tax rate on that $100,000 conversion from her bank account. Now Susan has $100,000 in a Roth IRA, $200,000 in her 401(k), $100,000 in her IRA and $165,000 in her bank account, as she used that to pay the taxes from the conversion.
In the second year, Susan converts the remaining $100,000 in the traditional IRA, again using her bank account to pay the taxes. By paying the
Roth conversion taxes from an outside account, Susan essentially supercharged her retirement savings by making a $70,000 contribution to her Roth IRA from her bank account. For example, a person with a $200,000 IRA subject to a 35% tax rate is equivalent to a $130,000 Roth IRA that is not subject to taxes. However, by paying the taxes from a taxable account, her personal savings at the bank, Susan has essentially moved $70,000 into the tax-advantaged Roth IRA by doing a conversion.
This strategy can help you save more money for retirement and create peace of mind that your retirement savings are yours and not the government's.
Jamie Hopkins is a professor of tax in The American College's Retirement Income Certified Professional program. Follow him on Twitter @jamiehopkins521.
