Why You Should Consider a Roth Conversion to Help Maximize Your Wealth

Are you within 5-10 years of retirement and hoping to maintain your current lifestyle, but most of your retirement is tied up in a traditional IRA? Continuing with your current plan means that unfortunately, you’ll have to pay taxes on your hard-earned retirement funds. And because you’re still working, it’s possible you might move up another tax bracket before retirement, meaning you’ll owe even more than you’re currently paying in income taxes.

What if I told you there was something you could do right now, to avoid income taxes throughout your entire retirement? Luckily, there is – it’s called a Roth conversion.

A Roth conversion is a process in which you transfer funds from a Traditional IRA, 401(k), or other tax-deferred retirement account into a Roth IRA. In the next tax season you would owe on the amount you converted, but once the funds are transferred they grow tax-free forever, as if you had a Roth IRA the whole time.

Particularly for high-net-worth individuals, a Roth conversion can be a game-changer. Traditional retirement savings strategies often involve significant portions of your wealth being tied up in tax-deferred accounts. As you get closer to retirement, owing taxes on those accounts can create trouble for your retirement goals and legacy planning. However, doing a Roth conversion would mean lessening your upcoming tax burden, avoiding RMDs, and allowing your future generations to enjoy tax free growth.

1. Mitigating Future Tax Liabilities

The tax landscape is always shifting and it’s likely taxes will increase in the future. Roth conversions allow you to take advantage of current rates. Although you’ll pay taxes on the converted amount in the year of the conversion, this may ultimately save you money in the long run if you anticipate being in a higher tax bracket closer to retirement (or after tax laws change).

After age 59 ½, qualified distributions from a Roth IRA are tax-free, as long as you wait 5 years after the conversion for your first distribution. So, funds withdrawn are not subject to income tax regardless of how much the account has appreciated. Both the original contributions and any gains contributions grow completely tax-free, allowing you to maximize your retirement income without the worry of taxes eating into your withdrawals.

2. Avoiding Required Minimum Distributions (RMDs)

Another reason wealthy individuals should consider Roth conversions is to avoid Required Minimum Distributions (RMDs). Once you turn 73, you must begin taking RMDs from your traditional IRA or 401(k), which are taxed as ordinary income. Unfortunately, RMDs can push you into a higher tax bracket and increase your tax burden. However, with a Roth IRA, there are no RMDs during the account holder’s lifetime. So, you could wait as long as you wanted before withdrawing, allowing you to avoid associated taxes you otherwise would be forced to pay.

3. Tax-Free Growth for Future Generations

As a firm with many multi-generational planning clients, we have seen the benefits of tax-free wealth transfers thanks to Roth IRAs. In contrast to traditional IRAs where beneficiaries must pay income tax on withdrawals, a Roth IRA allows heirs to take distributions without owing federal income taxes, maximizing the legacy your children or grandchildren will inherit.

One of the main challenges for high-net-worth individuals who want to open a Roth IRA is the income limits imposed by the IRS. In 2024, you cannot contribute directly to a Roth IRA if your Modified Adjusted Gross Income (MAGI) exceeds $153,000 for single filers or $228,000 for married couples filing jointly. If you are someone who exceeds these limits, you can still take advantage of a Roth conversion, through a backdoor Roth IRA.

In a backdoor Roth conversion, you first make a contribution to a traditional IRA. Since this is a non-deductible contribution, you won’t get a tax break on it. After, you then convert those funds into a Roth IRA. The conversion will be subject to income tax on any accrued gains but because the original contribution was non-deductible, you won’t be taxed on that portion.

There are no income limits on Roth conversions, making backdoor conversions an ideal strategy for high-income earners who want to fund a Roth IRA but exceed the limits for direct contributions.

Roth conversions offer many benefits, but they do come with important tax implications. The most immediate consequence of a Roth conversion comes from the fact that the IRS treats the conversion as a taxable event, meaning the amount you convert will be added to your taxable income for that year. If you’re converting a large amount, you may inadvertently push yourself into a higher tax bracket, resulting in a significant tax bill. For this reason, it’s essential to plan your conversions strategically – we suggest converting smaller amounts over multiple years to spread out the tax liability. Another option is to convert funds in a year when your taxable income is lower, such as in a year where you are not drawing as much income from other sources.

The additional income generated from a Roth conversion may affect other aspects of your financial life, including Medicare premiums. Higher income can lead to higher premiums as they are income-based.

A Roth conversion can be a highly effective strategy to minimize taxes, avoid RMDs, and leave a legacy of tax-free wealth for your children and grandchildren. And for high earners, a backdoor Roth IRA offers a way to take advantage of Roth conversions, even if you exceed the IRS’ contribution limits.

With proper planning, a Roth conversion can be a key tool in maximizing your wealth. As always, we recommend working with a team of professionals who understand both tax strategies and wealth management.