Roth Conversions Interest

There seems to be more interest in Roth conversions this year.

The reason people are asking more questions about Roth conversions is because of the tax-free growth that Roths provide coupled with the concerns of many people that taxes are going to go up sometime in the next few years and not only on people earning more than 400,000.

When you convert to a Roth IRA, you should always pay the taxes with outside of IRA after-tax dollars.

If you have $100 in an IRA, you don’t really have $100 you can spend. If you have $100 in a Roth IRA, you actually have $100 you can spend.

By converting a traditional IRA into a Roth you are supersizing your retirement asset.

In addition to future tax-free growth, another advantage for some Roth owners is that they do not have to take required minimum distributions. Also, their beneficiaries can continue to grow the Roth they inherit for another 10 years tax-free in most cases.

The disadvantage of converting a traditional IRA to a Roth IRA is the pain of paying the tax now. But you actually owe the tax and the tax has to pay some time. As my son says, would you rather pay tax on the seed or the harvest. One less painful way to get money into a Roth is to simply make a contribution into a Roth. Roth contributions are limited to 6000 or 7000 per year depending on your age. Also, many people cannot make a Roth contribution because they make too much money. For these individuals, they may be able to make a contribution to a traditional IRA and then immediately convert it to a Roth IRA. If you put say 7,000 into a traditional IRA and you do not deduct this contribution, your cost basis is 7,000 therefore there is no immediate tax consequence from this conversion. This strategy will not work as well if you have other traditional IRA’s currently due to the prorata rule.

For those who have traditional IRA’s, they might consider transferring their IRA’s to their 401k. This would allow them to use this “backdoor Roth” conversion strategy. In general converting to or contributing to a Roth IRA will benefit you in the long run. The sooner you get money into a Roth IRA, the more it will benefit you. In other words it will benefit a 30 year old more than a 60 year old. This is because the 30 year old will have more time for the money to grow tax free.

glass jar used for saving US dollar bills and notes for IRA retirement fundIf you want to give a smart gift to a child or grandchild, one that could truly be a gift that could last a lifetime, gift them some money to either pay the tax they incur for a Roth conversion or simply gift them some money to make a Roth contribution.

For the child to make a Roth contribution they have to have some earned income. If the child or grandchild earned $500 for baby sitting or for keeping their room clean, then they can deposit $500 into a Roth.

Another way to get more into a Roth is by making your 401k contributions into the Roth 401k option instead of a traditional 401k contribution.

This will be a little more painful than the traditional 401k contribution because the Roth 401k contribution is an after tax contribution, so you will not get a tax deduction for your contribution, but as long as you have a Roth for 5 years and are 59 or older when you first make withdrawals these withdrawals will be tax free as long as you live.

With a Roth contribution account or a Roth conversion account you do not defer your taxes, you legally avoid taxes. What could be better than that?

Craig M. McDaniel, CFP