How Much of Your IRA Should You Convert to a Roth IRA?

How Much of Your IRA Should You Convert to a Roth IRA?

The critical question facing many investors during their retirement planning is how much of their IRA they should convert into a Roth IRA. Obviously, you want to convert as much money as possible if the tax rate you will pay now is lower than what you will pay in the future, but not if you will pay more later than you will now.

Forecast your taxable income each year as you approach age 72, when you must begin withdrawing from your traditional IRA. Some key retirement planning questions to consider when converting include:

• When will you retire?
• When will your spouse retire?
• Will you receive dividends from investments?
• What will you receive in Social Security benefits?
• When should you claim your Social Security retirement benefits?
• What deductions will you have?
• Most importantly, what tax bracket will you be in?

For an optimum tax strategy, you generally want to spread the Roth conversion out over several years, which not only spreads out the taxes but may also keep you from moving into a higher tax bracket. But because of how favorable conditions are right now, you want to convert as much as you can within your current tax bracket, and you might want to consider converting some or all of the next tax bracket, as well.

The Tax Cuts and Jobs Act expires on December 31, 2025—and, with it, the ultra-low-income tax rates the law established. Now that the 2020 election is in the rearview mirror, several legislative proposals are now on the table that could increase tax rates sooner which would impact your tax planning. If you want to convert your IRA to a Roth IRA, now might be the time.

Of course, every individual’s investment strategy is different, and there are benefits and drawbacks to converting. Consult with one of our financial advisors in Prescott or Scottsdale to get a sense of whether converting to a Roth IRA is the right move for your tax strategy. Don’t wait too long, tax rates may not be this low again.

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Traditional IRA

There are two main advantages to the traditional IRA:

1) Up to certain income levels, your contributions are tax-deductible.

2) Your earnings are generally not taxed until they are withdrawn. You may also contribute the maximum amount—as of 2020, $6,000, or $7,000 if you are over 50—no matter how much money you make.

The downside to traditional IRA is that you must begin withdrawing funds once you turn 72 years old, and when you do, that money gets taxed at your then—effective rate. If you are in a higher tax bracket or tax rates have increased, you will take a hit.

Roth IRA

Let’s evaluate the pros and cons of Roth IRA.

Unlike with a traditional IRA, you do not have to pay taxes when you withdraw from a Roth IRA. Instead, the money is deposited into the account after-tax. Roth IRAs are thus well-suited to individuals who expect to be in a higher tax bracket or have a higher tax rate when they withdraw money.

Also, unlike traditional IRAs, there are no minimum required distributions. Roth IRAs do have a “five-year rule,” which means that if you withdraw the earnings on your contributions within the account’s first five years, you may be required to pay a penalty or taxes unless you are withdrawing the funds for specific, approved purposes.

There are two main drawbacks to Roth IRAs. The first is that contributions are not tax-deductible. The second is that if you make above a certain earned income threshold—as of 2020, $206,000 for a married couple filing jointly or $139,000 for a single filer—you are not allowed to contribute to a Roth IRA.

“Backdoor” Roth IRA

However, there is another tax strategy option for high earners: the “backdoor” Roth. In essence, you put money into a traditional IRA, then immediately convert your IRA to a Roth IRA.

You will, of course, pay taxes on the funds you withdraw from the traditional IRA, and you will not be able to claim a deduction on the money you put into the traditional IRA. There are some rules and best practices to follow to avoid penalties, so check with your wealth management firm to make sure this is the best option for your retirement planning. There are three ways to convert from an IRA to a Roth IRA.

• A rollover: A rollover is when you receive a distribution check and contribute it to a Roth IRA within 60 days.
• A trustee-to-trustee transfer: You would have one institution transfer funds to a different institution holding your Roth IRA account. This is where the financial institution holding your IRA transfers an amount to the institution’s trustee holding your Roth IRA.
• Same trustee transfer: This option is for people with both accounts at the same institution. The trustee at the same institution would transfer your money from the traditional IRA to the Roth IRA.

How Our Financial Advisors Can Help

These calculations can get complicated—but do not let that scare you off. Now is a good time to act. You may never again see tax rates as low as they are today. In addition, if there is another bear market as the country deals with the COVID-19 pandemic, that, too, offers a prime moment to convert from an IRA to a Roth IRA, pay taxes on the reduced portfolio, and benefit from tax-free wealth when the market recovers.

At Hosler Wealth Management, our financial advisors in Prescott and Scottsdale have been helping people with their retirement planning for over 25 years. Our wealth management team can help you navigate your retirement strategy and tax opportunities avoiding unnecessary taxes and penalties while maximizing your chances for a comfortable retirement. If you have questions about how you should convert from an IRA to a Roth IRA, contact Hosler Wealth Management today for more information or a free consultation by calling our Prescott office (928) 778-7666 or Scottsdale office (480)994-7342.

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