Roth Conversions: What they are and how they work!

A common question we receive when meeting with clients is “Should I convert to a Roth?” when discussing their retirement accounts. There are pros and cons to Roth Conversion and each situation requires an analysis of the individual or families’ financial picture. Before we get ahead of ourselves let’s discuss the basics.

Roth is a term used to identify AFTER TAX dollars. In a 401k or Traditional IRA people invest pre-tax dollars and are able to see those dollars grow from investments tax deferred. A Roth 401k or IRA is where people pay the taxes up front, then the money grows and there is no tax bill when it is withdrawn.

So what is a Roth Conversion? It is simply put, converting a Traditional IRA into a Roth IRA (or 401k, but this isn’t as common). The Traditional IRA account value is taxed at the individual’s current income tax bracket (paid Progressively) and transferred into a Roth IRA, where it will grow and not be taxed upon withdrawal.

When to do this conversion is specific to each individual, but based on simple math one can look at the two aspects of converting to a Roth: Account Value and Tax Bracket, and see that when these are both at their lowest, it is an ideal time to convert. If the market has taken a hit and the individual’s earnings are lower than anticipated, converting the IRA makes the most sense at that time.

Converting to a Roth may be a great way to offset business losses and seize an opportunity. If a business owner is going to harvest a loss for the year, they could convert their Traditional IRA to a Roth IRA in the amount of the loss and pay $0 in taxes for the conversion. They could extrapolate this and just use the loss to decrease the amount they have to pay. For example, if the owner has $50,000 in wages, a $40,000 business loss, and a $25,000 Roth Conversion, they would be left with the $35,000 in taxable income for the tax year.

You don’t have to convert the entire IRA, you can do it in portions. Be sure to talk to your Financial Advisor and your Accountant before initiating your conversions. If you would like a second set of eyes to review your situation and see if a Roth Conversion is the right fit for you, please contact us.