Investment Glossary – Roth IRA Conversion
A Roth IRA conversion is a process by which you pull money out of a Traditional IRA, pay the taxes on the distribution you are taking, and then directly transfer the funds into a Roth IRA, ensuring the proceeds can grow tax-free for the rest of your life. It is effectively a method for delayed financial gratification, in which you accept that you’re going to pay some taxes today in order to save on taxes later. So let’s get into the basic principles of it.
Remember that a Traditional IRA has money that is typically put aside via pre-tax contributions, meaning that you got a tax deduction for those contributions. The money in that Traditional IRA is going to (hopefully) grow over the course of your lifetime in a tax-deferred manner. When you go to withdraw the funds, the proceeds are taxed as ordinary income. So the key concept that you are working with inside a traditional IRA is tax-deferral.
A Roth IRA, on the other hand, is a tax-free investment vehicle. You put money in there today, you get no deduction, but then the money (hopefully) grows tax-free for the rest of your life, with no taxes required upon withdrawal of the funds.
With a Roth IRA conversion, you are voluntarily ending the deferral of taxes on all or a portion of your Traditional IRA. You are choosing to pay taxes. And that’s hard for a lot of people, because you are taking money out of your pocket today. And you’re not doing it for a new toaster, boots for the kids for winter weather, or because you need new windows in the kitchen. You’re doing it because you believe that despite paying that tax today, it is going to lower your overall tax burden in the future, and in doing so, leave you in a better financial position at a later point in time. That’s pretty much the definition of delayed gratification, right?
One other point – as of 2018, Roth IRA conversions are final. You can’t go back and undo them, so you better get them right the first time, because there is no chance for a mulligan.
Now, there are a couple things that you need to take into account when you examine whether a Roth IRA conversion is the right choice for you. You need to look at your tax bracket today and your projected tax bracket in the future. You need to look at how far into the future you might potentially need access to these funds. You need to look at potential changes to the tax code that may affect this planning and the likelihood of those changes being passed. For a lot of people, this kind of analysis is something they’d rather leave to a qualified tax professional, and that’s probably the right choice in many cases. CPAs and enrolled agents deal with this kind of planning on a regular basis and can likely give you a quick answer that saves you a bunch of time and worry as to whether you’re doing the right thing.
But the key question that we always want to return to is the simple one – “What am I doing, and why am I doing it?” In the case of a Roth IRA conversion, you are voluntarily surrendering your money today in order to avoid having to turn over larger amounts in the future. If you do the math and that doesn’t turn out to be the case, likely because your tax situation may in fact not be right for a Roth IRA conversion, then you need to put the idea of a conversion on hold until you are in a position in which that is the case. Roth IRA conversions can be a great tool for reducing your lifetime tax burden, but they require some legwork to make sure they’re executed properly and that they’re paying off the way you want them to be.