Roth Vs. Traditional, and When a Conversion Makes Sense

Roth Vs. Traditional, and When a Conversion Makes Sense

If a Roth conversion is right for you, you can save in taxes, improve your financial future and take advantage of a plan you may not have been eligible for initially. But do a Roth conversion at the wrong time and you can face hefty taxes, make decisions about your retirement that you can’t undo and move money that is no longer accessible for short-term goals.

We say it all the time at Montgomery Taylor Wealth Management: No two situations are exactly the same. Even two Sonoma County retirements can be very different. And this is definitely the case when it comes to a Roth conversion. This strategy has received a lot of attention lately, but it’s important to understand what it means before taking action. There can be benefits to converting your Traditional 401(k) funds to a Roth retirement account, but if you don’t plan carefully, you can end up making choices that will increase your tax burden, and possibly incur penalties.

So, does it make sense for you to convert funds in a Traditional retirement account to a Roth account? The answer depends on your circumstances, your income, your age and when you expect to retire.


Is a Roth conversion right for you? Contact the team at Montgomery Taylor Wealth Management to start a conversation.


Traditional Retirement Accounts Vs. Roth Accounts: A Difference in Taxation

Contributions to Traditional 401(k)s are made with pre-tax income. These contributions can significantly lower your current tax burden, because you can contribute up to $19,500 per year in pre-tax income (with an annual catch-up of $6,500 if you’re age 50 or over) in 2021.

Your withdrawals from Traditional 401(k)s will be taxed at your existing tax rate at the time of withdrawal.

Roth 401(k)s and IRAs work in the reverse: Contributions are made with after-tax income, so there is no immediate tax benefit at the time of contribution, but Roth accounts display their tax benefits when you make withdrawals in retirement. Withdrawals are not taxed.

Appreciation in both types of accounts grows tax-free until withdrawn.

A Roth conversion essentially allows you to switch account types, transferring the money you have in a Traditional account to a Roth account, and therefore, changing those tax benefits.



When a Roth Conversion Makes Sense

There are many situations where a Roth conversation may make sense.

1. If It’s Likely to Lower Your Overall Taxes

If considering a Roth conversion, ask yourself: Are the taxes I’d pay now, more than what I’d pay in the future? If the answer is no, talk to a financial advisor. (This can happen if you expect your future tax bracket to be the same or higher later in life, which is often the case with a Sonoma County retirement.)

Make note: A conversion will trigger a tax event for the Traditional account funds you plan to convert. Because they have not been subject to taxation, and because Roth contributions must be made with after-tax dollars, the Traditional account funds you plan to convert will be subject to tax in the year of conversion, at your ordinary rate. These costs can be high, so talk to a financial advisor about your options before moving forward.

2. If You Want to Avoid RMDs

Required Minimum Distributions (RMDs) are required annual withdrawals from Traditional retirement plans once you reach age 72. (If you turned 70-½ in 2019 or before, you should already be taking RMDs, as 70-½ was once the age threshold.)

Roth accounts are not subject to RMDs as long as you’ve held them for five years or more.

For many high net worth individuals, it can make sense to have flexible retirement funds that are not subject to these RMDs. If you don’t take your RMDs, the tax penalty is steep.

3. If You Can Benefit from a Roth IRA, But Make Too Much to Qualify

The challenge with Roth IRAs is that the IRS puts income restrictions on who can contribute. In 2021, if you earn $208,000 or more and are married filing jointly, you can’t contribute to a Roth IRA, and if you earn between $198,000 and $208,000, you can only contribute a reduced amount. Individual filers who earn $140,000 or more in 2021 cannot contribute to a Roth IRA either, and those who earn between $125,000 and $140,000 can only contribute a reduced amount.

A Roth conversion is a workaround to these income restrictions. In a Roth conversion, you transfer money from a Traditional retirement account to a Roth IRA, regardless of your income. This allows you to create the same tax-free income stream in retirement as if you’d contributed to the Roth IRA from the beginning.

The caveat is that you must wait at least five years after contributing to your Roth IRA to begin taking tax-free withdrawals. For this reason, the Roth conversion strategy doesn’t make much sense for someone who is less than five years from retirement.

If you think you’ll benefit from a Roth IRA in retirement but don’t qualify, a conversion can be a smart move.



When a Roth Conversion Doesn’t Make Sense

Likewise, there are circumstances when a Roth conversion just isn’t the right strategy.

1. If a Conversion Would Raise Your Overall Tax Burden

The point of a Roth conversion is often to minimize taxes, so it doesn’t make much sense to do a conversion if you think you’ll be in a lower tax bracket in retirement.

The tax bill at the time of conversion can also be steep! If you can’t pay the conversion taxes, it may not make sense.

2. If You Will Retire Within Five Years

Withdrawals from Roth funds are tax-free if you hold them for five years or more. The five-year period begins in the year of the conversion, not the year you first contributed the funds to a Traditional account.

If you are less than five years from retirement, it likely doesn’t make sense to do a conversion.

The Takeaway

As the first Certified Financial Planner (CFP) CPA in Sonoma County, at Montgomery Taylor Wealth Management, tax planning is a major element of a financial plan. A conversion is just one strategy that can help minimize the effects taxes have in retirement. Taxes can be exceptionally high for a Sonoma County retirement.

Montgomery Taylor Wealth Management is a Santa Rosa-based firm serving the greater Sonoma County area. Our team of financial advisors, certified public accountants and estate planning attorneys provide clients with integrated, complete financial advice to help simplify our clients’ lives and maximize their opportunities.

If you have a question that is not addressed here or would like to discuss your specific situation in more detail, schedule a no-obligation conversation with our team. We’re here to help!

Montgomery Taylor Realistic Financial Planning