By SJS Investment Services Senior Advisor Andrew Schaetzke, CFP®.
Taxes may be one of your most important considerations in the design and implementation of your investment strategy. We want to help you increase after-tax returns, subject to your particular investment plan.
When you have some combination of taxable, tax-deferred, and tax-exempt investment accounts, assuming the same investments, we expect your after-tax returns to be higher for tax-advantaged (tax-deferred and tax-exempt) accounts compared to taxable accounts.
One specific tax-advantaged account - the Individual Retirement Account (IRA) - has an important feature that can potentially help you increase your after-tax expected returns over time.
Individual Retirement Accounts (IRAs): Traditional IRA Vs. Roth IRA
An IRA is meant to help people save for retirement in a tax-efficient way. There are two types of IRAs:[1]
Traditional IRA: As long as your taxable income (MAGI) is not above the Traditional IRA deduction limit, the money you put into the account is not taxed and may be deducted from your income up to $6,000 in 2021 ($7,000 if over age 50). When you withdraw money from the account at a later date, it is taxed at ordinary income tax rates.
Roth IRA: As long as your taxable income (MAGI) is lower than the Roth IRA income limit, the money you put into the account is taxed now with no deduction. The money taken out of the account at a later date after age 59 1/2 is not taxed at all.
For a more thorough explanation of Traditional IRAs and Roth IRAs, please see this IRS website.
Converting A Traditional IRA To A Roth IRA
Depending on your individual circumstances, you may consider converting your Traditional IRA to a Roth IRA in an effort to increase your longer-term after-tax expected returns. As part of the process, you have to pay federal & state income taxes now on the amount of money that you convert. There are many reasons you may consider converting to a Roth IRA, including:
More tax-free withdrawals in retirement
Watch your money potentially grow tax-free longer
Decreasing future tax burden for beneficiaries of your Traditional IRA
You may be a good candidate for a conversion if:
You are paying lower federal & state income tax rates now compared to expected taxes in the future.
You have lower taxable income this year compared to expected future years.
You want to lower the required minimum distributions (RMDs) from the Traditional IRA.
You are interested in lowering your Medicare IRMAA surcharges by decreasing future taxable income (MAGI).
You want to feel more in control of your future tax burden.
For more information on IRA conversions, please see this IRS website.
Risks of Converting A Traditional IRA To A Roth IRA
Rolling over a significant balance to a Roth IRA could put you into a higher income tax bracket and leave you with a bigger tax bill this year. If tax rates decrease in the future, you may end up paying more taxes by converting now relative to in the future. The regulatory rules and income limits surrounding conversions can be complex, and it is easy to make mistakes during the conversion process, which may complicate filing your taxes, potentially lead to the 10% penalty, and could lead to an IRS audit. Assets converted to a Roth IRA must be held in the Roth IRA for at least five years before withdrawing in order to avoid a 10% penalty. Depending on your conversion method, you may not be invested during the conversion period. Additionally, the conversion may cause you unnecessary stress.
Summary
Converting a Traditional IRA to a Roth IRA is highly dependent on your unique circumstances. SJS can help you review your current situations, and analyze the benefits and tradeoffs of conversions. As always, please work with your tax advisor to appropriately complete any IRA conversion and associated paperwork.
IRA conversions are just one of the many ways that SJS helps people potentially increase their after-tax expected returns over time. If you want to learn more about other ways and how SJS may be able to help you, please feel free to reach out to us.
Important Disclosure Information And Sources:
[1] “Traditional and Roth IRAs“. IRS, irs.gov.
[2] “IRA FAQs - Rollovers and Roth Conversions“. IRS, irs.gov.
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