How Roth Conversions May Save You Money on Taxes

Tax filing is typically a 'look in the rearview mirror' approach when documenting the prior year's taxable events. You record them on your tax return and pay your taxes accordingly. However, much like driving a car, when we refocus on the road ahead, we find there are many directions to take for optimal tax planning.

One such direction is performing Roth conversions.

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What is a Roth conversion?

A Roth conversion is the process of moving assets from a pre-tax retirement account, such as a traditional Individual Retirement Account (IRA), to a Roth account and paying ordinary income tax on the amount converted.

Benefits of Roth conversions

Roth conversions can potentially help you lower your taxes in the long run by reducing your Required Minimum Distributions (RMDs). When you reach a certain age, the IRS requires you to withdraw annually from your traditional retirement account(s).This counts as income and thus, a tax bill to go with it. Your RMD is calculated based on your life expectancy and your prior year-end
account balance.

Roth conversions may lower your RMDs by shrinking your pre-tax account balance. Roth IRAs are not subject to RMDs, allowing the converted assets in the account to grow tax-free. This can be an extremely favorable strategy, especially as taxes are likely to increase over the next few years. By utilizing Roth conversions, you are in control of when to pay taxes and on how much.

In addition, there is the benefit of having a tax-free bucket with the ability to pass assets tax-free to the next generation, who like you, do not have to pay tax on future earnings or distributions.

Rules for Roth conversions

Some Roth conversion rules to remember are:

  • A Roth conversion is a taxable event. You must pay income taxes on the amount converted from your traditional account.
  • If you plan to do Roth conversions, consider talking with your CPA or Investment Advisor regarding estimated tax payments.
  • The money you convert must remain in the Roth account for five years. If you withdraw before then, you may be subject to income taxes and a 10% penalty.
  • If you are eligible for an RMD, you must take any RMDs from pre-tax accounts before you convert funds to a Roth IRA.
  • Unlike Roth IRA contributions, there are no limits to the amount you can convert to a Roth IRA.
  • There are no age or income restrictions for Roth conversions.

Please keep in mind that Roth conversions are not for everyone and may not be suitable for your situation. If you are near retirement age and earn a high income, you may not benefit from a Roth conversion until you retire.

However, younger earners may benefit from the longer time horizon to retirement to allow their Roth accounts to grow and may outweigh the tax implications from converting in a larger tax bracket due to higher income. Roth conversions are more suitable for those with liquid assets, like cash or a taxable brokerage account, to pay the
increased tax bill.

If you are curious about Roth conversions, reach out to your DCM advisor to determine if they are right for you.

This report was prepared by Donaldson Capital Management, LLC, a federally registered investment adviser under the Investment Advisers Act of 1940. Registration as an investment adviser does not imply a certain level of skill or training. The oral and written communications of an adviser provide you with information about which you determine to hire or retain an adviser. Information in these materials are from sources Donaldson Capital Management, LLC deems reliable, however we do not attest to their accuracy.

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