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Roth Conversions vs Roth Contributions Thumbnail

Roth Conversions vs Roth Contributions


Hey guys, Mike Frontera here with Retirement Theory!

So here’s an interesting question I got recently—“Mike, I’ve got $5000 that I want to put toward retirement. Am I better off contributing that $5000 to my Roth IRA directly OR should I convert enough of my Traditional IRA to my Roth to generate a $5000 tax bill?” I love this question because we’re really trying to optimize the resources that we have here to make the best retirement decisions.

Of course, as you know, I love my Roth IRAs…they are right up there as of the best deals that the IRS gives us. And I’m absolutely crazy about Roth conversions in this low tax rate environment because in a sense we get to leverage our dollars to these push big chunks of our retirement into that tax-free zone.

Right, so generally speaking, if I have $5000 in my hands to put toward retirement, I’d much rather use it to pay taxes on a conversion rather than make a new Roth contribution. Now, let’s emphasize that “generally speaking” part because there are times where a conversion is about the last thing that you’d want to do.

OK, let’s check this out!

Let’s start with Pam:

She’s 45 years old, married with a household income of $75,000. Now, I’m going to make life easy and say she lives in Florida, where there’s no state taxes. Though if you do live in a state with a state income tax, that can throw a couple other wrinkles that can skew things a bit one way or the other. More on that in a bit.

Alright. Pam has $100,000 in her IRA, she’s got $5000 in cash (aside from her emergency funds of course), and she’s got $25,000 in her Roth IRA.

In scenario 1, Pam contributes $5000 to her Roth IRA directly. Now, 20 years later, assuming a totally hypothetical made up rate of return of 5% for both the IRA and Roth, and no other deposits she now has: $265,330 in her IRA and $79,599 in her Roth.

Scenario 2, Pam uses her $5000 to convert money from her IRA to her Roth. She’s currently in the 12% Federal tax bracket and can convert $41,667 of her IRA to Roth to create a tax bill of $5000! We fast forward again with that same hypothetical made-up 5% rate of return, and lo and behold, she now has:

$154,775 in her IRA and $176,887 in her Roth

Now, if she were to take money out in retirement at the same 12% tax rate, she nets out:

$313,089 in scenario 1 and (drumroll please)….$313,089 in scenario 2.

Hmm. OK, then what’s the difference?

Well, the difference is that we’ve hugely increased the amount of money that we’ve pushed over into the Roth in scenario 2 vs scenario 1. So… if tax rates DO increase we’ve made a much greater impact on our ability to deal with it.

So why would tax rates increase in retirement?

Let’s see:

  1. Well first, we got the Tax Cut and Job Act rates that expire in 2026. Unless tax laws change between now and then, most tax brackets are going to jump 3%-4% in each bracket.
  2. You have Required minimum withdrawals. You know, that time when you have to take big chunks of our taxable retirement accounts out each and every year?
  3. How about a big spending need: Have to draw a bunch of money out for a major home repair, a family emergency, or even worse, long-term care? Think about how a major withdrawal out of your taxable account what that might do for your tax rate vs having a big chunk of money that is in your Roth IRA that you could pull out and not impact your income.
  4. If you’re married filing jointly, and your spouse passes away, suddenly you’re a single filer where those income thresholds for most people are basically cut in half before you reach that next tax rate.

That’s just four examples I could think of. And that doesn’t even talk about the interplay between Social Security and taxable income, or if additional potential tax rate hikes may be coming down the road!

The point is, if you’re in a lower tax bracket now and you can foresee you are going to be in a higher one down the road, you can make a much larger impact doing Roth conversions versus Roth contributions.

Now of course, sometimes conversions don’t make much sense at all.

What if you expect to be in a lower tax rate in retirement? That could be the case if you live in a state that has income taxe that you pay now and you are moving to a state that doesn’t in the future. Or if you just happen to be in a higher bracket because your income is higher.

How about over-converting? You pay a bunch of taxes on these conversions along the way, not realizing that your remaining pre-tax money is now getting so low that you could have just left it and drawn it later or a low or zero tax rate.  

Finally, what if you’re under 59 ½ years-old and you think you may need to grab that money back out soon. So with a Roth conversion, you have 5 years starting Jan 1 of the year you do your conversion before you can touch any money, otherwise you’ll be subject to a 10% penalty on all of the money plus taxes on any of the growth. With a Roth contribution all of the principle of your Roth, that entire contribution, is available to you. It can be withdrawn at any age, for any reason. So much more flexible.

Roth conversions are sort of like turbo-charging your Roth decisions versus contributions. When it makes sense, it can make a lot of sense. But when it doesn’t, you’re need to steer clear.

So, questions for me?? Let me know! Visit me at www.retirementtheory.com. Send me an email at mike@retirementtheory.com. Of course, be sure to like this video if you found it helpful and click that subscribe button to see more videos like these on everything retirement planning. See you next time!


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