All About Roth Part I: The Roth Conversion
The concept of “Roth”, while established more than 20 years ago, still creates some confusion due to the many avenues it can take. For example, a Roth IRA is different than a Roth 401k and has differing rules that dictate how they operate. Additionally, terms like “Roth conversion” or “backdoor Roth” penetrate the masses but there is often some confusion associated with what each of those are. Today’s post uncovers the basics of a Roth Conversion and why someone would consider this tactic.
First, let’s begin with the creation of Roth as a concept. This all started with Senator William Roth in 1997 when the “Taxpayer Relief Act of 1997” was passed. This established the Roth IRA, which is similar to an IRA in that it is in an individual’s name and intended for retirement, but it differs in the fact that there are some specific tax benefits.
Namely and the most commonly quoted benefit is that when you contribute to the account, the contribution is not deferred (like a traditional IRA) meaning one wouldn’t gain a tax benefit today from contributing, however, if the money withdrawn from the account is a qualified withdrawal, the principal AND earnings are completely tax free. Let’s see a simplistic example:
If you were to contribute $2,000 per year to a Roth IRA for 20 years and assume a 6% return over that time frame, you’re looking at about $33,000 in gains that are completely tax free, as long as those funds are pulled out via a qualified withdrawal.
Another notable quality of a Roth IRA includes being able to use the funds without penalty for certain identified needs such as a first-time home purchase, educational expenses, and certain healthcare expenses.
A few other important things to note about this type of account include:
· Maximum contribution is the same as an IRA at $6,000 in 2020 (adjusted every so often for inflation) with a $1,000 “Catch Up” contribution if you’re 50 years old.
· Income “phaseout”, meaning that if you make above a certain income level, you aren’t eligible to contribute to a Roth IRA at all. This changes annually but for 2020 as a single person your modified gross income needs to be less than $139,000 and as a married couple $206,000. There is a range of 10k-15k less than those figures where you can contribute a lesser amount than the full contribution.
Why contribute to a Roth IRA?
Aside from this being an additional vehicle you can utilize for retirement funds, why would someone choose a Roth over a Traditional IRA?
This gets a little tricky and drives individuals to take on different strategies. While being able to defer income through a traditional IRA is great for the current tax year, once money needs to be pulled from these accounts later in life (ex. retirement), every single dollar is taxable. This wouldn’t be too big of an issue if someone planned to live off of a pretty meager amount in retirement, (lower than their working income for example) however, it comes down to what will your income look like once you start pulling from these accounts?
The common question that arises is “Do you believe you’ll be making more money per year in retirement or less money per year in retirement?” This question is essentially getting at this exact planning conundrum.
We, as financial advisers are trying to determine whether deferring taxes is a better option or contributing to Roth is a better option. Or better yet, a combination of both…and that’s often where a Roth conversion may come into play.
What is a Roth Conversion?
Now that we have the basics down, lets get into a “conversion.” This concept simply means that we are taking pre-tax dollars (for example in a traditional IRA) and we are converting them into Roth dollars to be used at a later time. So why would we do this?
Typically, a Roth conversion is recommended because someone may have a lot of pre-tax money and is getting close to or is already early in retirement. When this conversion occurs, the entire amount of the conversion is completely taxable in that tax year, increasing that individual’s income so this needs to be a very thoughtful process. The end result, though, is now the converted dollars can grow completely tax free as long as the rules for a qualified withdrawal are met.
Additionally, there is a five-year rule that applies to conversions that is important to be aware of. When you open a Roth IRA and contribute, it starts a 5-year clock from January of the taxable year the contribution is for and if you pull funds out prior to a full 5 years, you’ll typically pay a penalty on the earnings. This only applies to the first contribution (not ongoing contributions to a Roth IRA), however with a conversion, there is a completely separate 5-year clock that begins from the year of conversion.
What about Roth within Employer Plans (401k)
This entire post has been related to Roth IRAs since those are usually applicable to a greater audience, however, Roth money within a 401k for example, can exist. This is at the discretion of the employer when they create the plan to allow for Roth contributions and/or to allow for Roth conversions. Many qualified and non-qualified plans have begun adopting this and offer what is called an “in-plan Roth conversion” meaning that the conversion happens within your existing 401k plan.
As with any of complicated financial matter, rely on a financial professional to help you with the calculations to ultimately determine the best path for you. Stay tuned for additional details about Roth in future posts.