Should You Do a Roth IRA Conversion in 2021?
What Makes a 2021 Roth Conversion so Compelling?
Because of the tax-free growth that Roth IRA accounts provide, they have always been viewed an effective retirement planning tool. But two recent pieces of legislation have made this an especially advantageous time for retirees and those approaching retirement to consider a Roth conversion:
The Tax Cuts and Jobs Act of 2017, which lowered tax rates starting in 2018 but is set to sunset at the end of 2025; and
The SECURE Act of 2019, which eliminated the popular “Stretch IRA” strategy for those who plan to leave assets in a tax-deferred retirement account to their children or grandchildren.
Throw in the growing national debt and worries about how the government will continue to pay for programs like Social Security and Medicare, and you’ve got the perfect storm putting pressure on lawmakers to consider raising taxes. With higher taxes on the horizon, you can see why Roth conversions are getting so much attention. If you think taxes will be higher in the future (and most people do), converting Traditional IRA assets to a Roth can make a lot of sense.
Converting Pre-Tax Retirement Money to Roth
Timing is everything with Roth IRA conversions. Whether now is the right time for you depends on where you are in life. Are you still working? Retired? Have you lost your spouse? All of these considerations play an important role in your decision.
The Roth IRA allows your investments to grow tax-free, distributions are not taxed, and there are no required minimum distributions (RMDs). Combined, these benefits can help reduce your lifetime tax burden and increase the longevity of your retirement nest egg. Strategic use of a Roth IRA ensures you can invest for the growth your long-term plans need while managing your income in a way that creates tax efficiency.
Traditional IRAs, 401(k)s, and 403(b)s all mandate annual RMDs to be taken, starting at age 72.2 The amounts of these change from year to year based on the value of the plan, and they are taxed as ordinary income. This can have a ripple effect and potentially increase your tax liability if your distributions from these accounts are high enough that they push your total income over certain income limits. This can result in pushing you into a higher tax bracket, increasing the taxation of Social Security benefits, or result in increased Medicare premiums. on how much of social security benefits is untaxable.
Besides the tax implications, your investment strategies must be managed around the need to generate cash to fund RMDs, which can force you to liquidate investments at points where you might prefer to stay invested - like during a bear market. This forced selling can impact your long-term returns.
By converting these accounts to Roth IRAs, you eliminate RMDs and the possibility of being forced to sell holdings at low prices. This may allow for a more effective tax management strategy. As a result, you can keep more of your nest egg geared toward longer-term growth-oriented investments, since there’s no need to plan for distributions beyond what you need for income.
The When and the How to Pay for It Matters
To avoid a big jump in income in any one year, which can impact social security taxes and also result in you having to pay a Medicare surtax, it may make more sense to set a plan to complete your Roth Conversion over the course of several years, so that you can manage the impact to income and taxes.
Since, as mentioned above, gains in a Roth IRA do not carry a tax burden, returns on a Roth IRA may be higher. Funding the tax bill resulting from a Roth conversion from taxable assets, such as those in a brokerage account, can increase returns over time. The returns from the brokerage account are reduced by the amount of tax paid, while the returns in the Roth IRA earn a pre-tax rate. If you haven’t reached age 59 ½, it’s particularly important to use taxable assets since withdrawing from the traditional IRA or 401(k) will trigger a 10% tax penalty.
One Caveat
No matter what stage of life you’re in, you’ll also want to be aware of the “Five-Year Rule” on Roth Conversions. Basically, if you withdraw earnings from a Roth IRA that you have not held for at least five years, you’ll have to pay taxes on your earnings. You won’t have to pay taxes on your contributions, because you’ll already have done that when you moved the money. But if your goal in opening a Roth is tax-free growth, you’ll have to give it time to make that work.
The Bottom Line
Even if you did not set up a Roth IRA at an earlier stage of your career, it can still be an effective tool in retirement. It just requires some careful planning to manage the conversion from a traditional IRA or 401(k), to be sure it works for your situation.
The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but is intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or personalized financial advice. Please consult a legal, tax, or financial professional for information specific to your individual situation.
