Roth IRA Conversions

Is Deferring Taxes the Best Thing for Your Retirement Savings?

The tax bill that you’re putting off on your traditional IRA or 401(k) may be higher than you think, especially since it’s looking likely that tax rates could be rising sooner rather than later.

Many people saving for retirement have long followed the tax-deferral concept behind a traditional 401(k) or IRA. One benefit they see is lowering their tax bill during their working years by making before-tax contributions to their retirement savings plan(s). While the concept of tax savings now sounds appealing, many overlook the potential implications for the future.

You see, while they’ve saved on their taxes presently, the burden of paying taxes on those funds has shifted to the future when withdrawing them in retirement at an unknown tax rate. As time goes on, this concept is beginning to look risky to those whose retirement savings have yet to be taxed, especially when rising tax rates seem inevitable.

The big problem is the growing national debt. It has doubled in the past 10 years, from $14 trillion in 2011 to $28 trillion in 2021. A lot of people in the financial services industry and most of our clients feel that taxes likely will go up due to this crushing debt. And as a result, taxes could heavily impact 401(k) and IRA distributions in the future.

With the rapid increase of our national debt comes the likelihood of taxes rising. With money inside of your pretax retirement accounts, one way or another, you will eventually have to pay taxes on these funds upon withdrawal. It’s up to you whether you want to pay the tax now, at the current known rate, or later at a future unknown rate. Given the current economic environment, for many, the preference is to pay tax now.

Roth to the Rescue

The solution comes in the long-term tax benefits of a Roth retirement account. The big difference between a traditional and a Roth retirement account is how they are taxed.

With a traditional IRA/401(k) all contributions are made pretax and distributions are taxable. With a Roth IRA or Roth 401(k) you pay tax now on the initial contribution, but all qualified distributions — including any growth — are withdrawn tax-free in retirement.

While in the past, the traditional retirement account was the only option for many employees, we are starting to see more employers offer this Roth option within their company retirement plans. You can open your own Roth IRA to take advantage of these tax benefits or even convert existing IRA funds to a Roth.

Here are some points to consider about making a Roth conversion:

Roth Conversions: It’s Not Too Late to Take Advantage

Converting to a Roth from a traditional pretax account is one way out of the high-tax-in-retirement predicament, and a conversion can be done at any age. However, many people are unaware of this option or the fact that, unlike contributions, there is no limit as to how much money you can convert annually. While the amount that you convert counts toward your taxable income for that year, you will get the future benefit of tax-free distributions from your Roth account in retirement. This becomes beneficial to those who are already retired looking for additional income sources without bumping into a higher tax bracket.

In addition to the tax benefits, Roth IRAs are not subject to required minimum distributions (RMDs) at age 72 like a traditional IRA or 401(k). This allows the money you’ve socked away to continue to grow tax-free until you choose to access it.

Contribution limits

Generally, you contribute to a Roth in one of two ways – through a Roth 401(k) or a Roth IRA. It’s important to know the contribution limits for both.

  • For a Roth 401(k) in 2021, $19,500 is the maximum, and people who are 50 or older can make an additional $6,500 catch-up contribution. Those limits are the same at they are for traditional 401(k) accounts. Some people may benefit by investing in both a Roth 401(k) and a traditional 401(k), but if you do so, the total amount you can contribute to both plans can’t exceed the annual maximums for your age – either $19,500 or $26,000 for 2021. 
  • For a Roth IRA in 2021, the maximum contribution is $6,000, and for those aged 50 and over, it is $7,000.

While contributing to a Roth may be beneficial, don’t miss out on the opportunity for free money. Most employers offer a company match on your retirement contribution; however, that match is usually on your pretax contribution. Generally, we suggest contributing to the traditional/pretax portion of your retirement plan up to the matching amount, and make any additional contributions to the Roth side.

Using both a Roth 401(k) and the traditional plan diversifies the tax status of your retirement savings. That way, whether taxes go up or down, you have both taxable and nontaxable accounts you can pull from.

Impact on Your Estate

The Roth conversion is also a tax buffer for those who inherit an IRA. The SECURE Act of 2019 changed the rules dramatically; now when someone inherits an IRA and is not the spouse of the person who owned the IRA, they have to withdraw all that in money within a 10-year period. With a traditional IRA, all of those withdrawal are taxable. But when your beneficiary inherits a Roth, although they too must draw down the account within 10 years, all their distributions are tax-free.

It has never been more important to be proactive in tax planning for your retirement.

The writing is basically on the wall for higher taxes in the future, and converting and contributing as much as you can to a Roth could potentially save you money on taxes in your retirement years. 

Dan Dunkin contributed to this article.

Investing involves risk, including the potential loss of principal. Neither the firm nor its agents or representatives may give tax or legal advice. Individuals should consult with a qualified professional for guidance before making any purchasing decisions.
Please remember that converting an employer plan account to a Roth IRA is a taxable event. Increased taxable income from the Roth IRA conversion may have several consequences including (but not limited to) a need for additional tax withholding or estimated tax payments, the loss of certain tax deductions and credits, and higher taxes on Social Security benefits and higher Medicare premiums. Be sure to consult with a qualified tax adviser before making any decisions regarding your IRA. It is generally preferable that you have funds to pay the taxes due upon conversion from funds outside of your IRA. If you elect to take a distribution from your IRA to pay the conversion taxes, please keep in mind the potential consequences, such as an assessment of product surrender charges or additional IRS penalties for premature distributions.

About the Author

Jonathan Imber, Investment Adviser and Registered Financial Consultant (RFC®)

Vice President, Imber Wealth Advisors Inc.

Jonathan Imber is an Investment Adviser and Registered Financial Consultant (RFC®) and vice president of Michigan-based Imber Wealth Advisors Inc. (www.imberwealth.com) and Imber Financial Group LLC, a registered investment advisory firm. He has a bachelor's degree in marketing and business administration from Northwood University, and holds licenses in both insurance and securities.

The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.

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