In our Monthly Financial Jargon series, with the end of the year drawing closer, we are diving into a term that is a potentially valuable tax-saving strategy you may want to consider taking advantage of before year-end: Roth Conversion.
A Roth Conversion relates to individual retirement accounts (IRAs), and this strategy involves converting from a traditional IRA to a Roth IRA. As a reminder, an IRA is separate from an employer-sponsored retirement plan – like a 401(k) or a 403(b) – and this type of account allows you to save for your retirement in addition to your employer-sponsored plan if you have one. IRAs bring potential tax savings if you understand the benefits of the different tax incentives the two main types of IRAs – Traditional and Roth – offer.
To understand what a Roth Conversion is and why you may want to consider leveraging one if you are able to, it is important to comprehend the differences between a Traditional and a Roth IRA.
Both Traditional and Roth IRAs are beneficial accounts to consider when it comes to supplementing your retirement savings outside of your employer-sponsored retirement plan. First and foremost, you need to determine if you qualify for a Roth IRA. For 2022, individual tax filers must have a Modified Adjusted Gross Income (MAGI) under $144,000 to contribute to a Roth IRA; if you are married and filing taxes jointly for 2022, your MAGI must be under $214,000. Keep in mind that the maximum total annual contributions for all IRAs combined is $6,000 if you are under age 50 and $7,000 ($6,000 plus a $1,000 catch-up contribution) if you are age 50 and older.
A Traditional IRA tends to be best suited for someone who anticipates being in an equal or lower tax bracket in the future when he or she begins taking withdrawals from the account, while a Roth IRA is typically best suited for an individual who expects to be in a higher tax bracket when he or she starts taking withdrawals. Put simply, the decision between which type of IRA is optimal for your financial life depends on which type of account will allow you to optimize your tax savings. A prudent question to analyze: will saving on taxes now benefit you most or will saving on taxes in the future bring you the most savings?
Fundamentally, if you are eligible to do so, converting a Roth IRA can save you money in retirement if it makes financial sense for you to pay taxes on retirement savings now as opposed to in the future. Remember how we discussed income limits for contributing to a Roth IRA? Well, there is a workaround to those restrictions, and this strategy is known as a Roth Conversion. A Roth Conversion allows you to convert existing traditional IRA funds to a Roth IRA, regardless of income level. Here are a few important conditions to consider:
If and when you conclude that a Roth Conversion is beneficial to your financial life and you want to move forward with the strategy, there are several important items to keep in mind.
For now, there are no basically no limits on how many Roth Conversions you can make from a Traditional IRA and no restrictions on the amounts of your conversions. Keep in mind that the deadline to make a Roth Conversion for the current year is December 31.
Which type of IRA is right for you depends on your specific retirement goals, current tax bracket and projected future tax bracket, among other aspects of your financial life. To make a well-educated decision, you need to decide if it makes more financial sense for you to enjoy tax-free withdrawals in the future via a Roth IRA or if it is more financially prudent for you to take immediate advantage of tax benefits through a Traditional IRA. Remember, when executing a Roth Conversion, you can convert all or simply a portion of funds in your Traditional IRA to a Roth IRA – it is not an all-or-nothing strategy, and it may be prudent for you to do a certain amount and not your whole account. Consult with your financial advisor about whether or not a Roth Conversion would be a valuable strategy to leverage in your financial life.
Monthly Financial Jargon: The world of finance and investments is notorious for its extensive use of jargon. With a goal to enhance financial literacy and make the world of money more transparent, we have our “monthly jargon” articles that focus on debunking financial terms that are often used sans explanation.
Questions and/or interested in how this applies to your financial life?
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