Money expert Clark Howard calls himself “the man from Roth.”
He so loves Roth IRAs that it’s a small miracle his dogs are named Kirkland Signature and Winston Churchill rather than Roth.
If you don’t have an IRA yet, you can open a Roth IRA. And if you have a traditional IRA, you can still consider converting it to a Roth IRA.
In this article, I’ll explain what a Roth conversion is, why you should consider converting your traditional IRA to a Roth and how these conversions work.
Table of Contents
- What Is a Roth Conversion?
- Why Would You Do a Roth Conversion?
- How Do You Convert a Traditional IRA to a Roth IRA?
- Should Older Adults Still Consider a Roth Conversion?
What Is a Roth Conversion?
A “Roth conversion” takes place when you take an existing traditional IRA and transform it into a Roth IRA.
It helps to understand the difference between a traditional and a Roth IRA.
You’re putting in pre-tax dollars when you contribute to a traditional IRA. In layman’s terms, the money you contribute toward a traditional IRA reduces your taxable income for the year. If you make $105,000 but put $5,000 into a traditional IRA, you’re only taxed on $100,000 of income.
You’re putting in post-tax dollars when you contribute to a Roth IRA. This means that the money you contribute toward a Roth IRA does not reduce your taxable income. If you make $105,000 but put $5,000 into a Roth IRA, you’re still taxed on $105,000 of income.
When you withdraw money in retirement, the money you take out of a traditional IRA will count as taxable income for that year. However, you’re able to withdraw the money (and earnings!) you put into a Roth IRA tax-free.
A Roth conversion takes place when you convert money in a traditional IRA to a Roth IRA. To do this, you pay taxes on every cent you convert.
Why Would You Do a Roth Conversion?
The biggest reason that Clark prefers a Roth to a traditional IRA comes down to taxes.
Clark is adamant that our relative tax rates will increase in the future. So unless you’re in a high-paying job that puts you in one of the highest tax brackets now, taking your medicine and paying the IRS upfront should save you money long-term.
Plus, in a de facto way, you’ll have more spendable money in retirement via a Roth. If you have $500,000 in a traditional IRA and $500,000 in a Roth, your accounts aren’t equal. Because you’ll owe taxes on the traditional IRA money. Some of your traditional IRA balance belongs to the IRS.
You can use our Roth IRA vs Traditional IRA calculator to see the differences.
Roth IRAs also allow you to withdraw your contributions (not your investment earnings) at any time. You aren’t forced to take Required Minimum Distributions (RMDs) from a Roth IRA. And they are better inheritance vehicles than traditional IRAs (more on that later).
How Do You Convert a Traditional IRA to a Roth IRA?
If you’re like me, you may read “convert your traditional IRA to a Roth IRA” and immediately get a headache. Or start to sweat out of stress.
It’s fair to assume that it’s a complicated process that will take a Herculean effort to figure out. But — surprise! — converting a traditional IRA to a Roth IRA is pretty simple.
Step 1: Open a Roth IRA
If you don’t already have a Roth IRA, open an account. Clark recommends low-cost discount brokers Fidelity, Schwab and Vanguard.
You may consider opening your Roth IRA account with the same company that manages your traditional IRA. Especially if it’s with one of those three Clark favorites.
Step 2: Transfer Your Assets From Your Traditional IRA To Your Roth IRA
If you’re doing an in-house transfer — for example, from a Fidelity traditional IRA to a Fidelity Roth IRA — get in touch with the company’s customer service department. They’ll be able to walk you through the process.
If you’re moving money from an outside firm, contact them and tell them you’re converting your traditional IRA into a Roth IRA at a new investment company.
Step 3: Pay Taxes on the Money You Convert
Remember, you’ve never paid taxes on the money you’ve put into your traditional IRA. The IRS expects you’ll give them their cut once you withdraw money from it in retirement.
But if you instead convert the money into a Roth IRA, you won’t owe the IRS anything when you withdraw in retirement. So the IRS expects you to pay them immediately.
It’s smart to know your tax bracket and your taxable income. If you make $100,000 this year and you’re converting a traditional IRA with $200,000 in assets to a Roth IRA, you’ll owe taxes on $300,000, for example.
Make sure you have enough money to handle your tax bill first. If you’re already in a high tax bracket, you may save money by avoiding this conversion. Even if the relative tax rates increase in the future.
Consult with a CPA or tax advisor if you have any questions.
Should Older Adults Still Consider a Roth Conversion?
Remember, Clark’s main thesis is that taxes will rise in the future. So it’s better to pay taxes now.
But what if you’re near retirement … or already retired? Is it too late to execute a Roth conversion?
For many people, the answer is yes. Stick with a traditional IRA. But if you’ve accumulated significant assets, there are three reasons why you should still consider a Roth conversion in your 50s and 60s.
“Those are the people that are least likely to do a conversion from a traditional to a Roth even though they benefit the most,” Clark says of the wealthy.
“And the reason they won’t do it is they think, ‘Well, I’m in such a high tax bracket right now. Why would I do that? Because if in retirement I have a lower tax rate, I’ve cheated myself by paying more tax doing a conversion.'”
Here’s why Clark says you should consider converting your traditional IRA to a Roth IRA when retirement is imminent or when you’ve recently retired. This is if you have significant assets:
1. Medicare Taxes
Most people don’t think about the cost of healthcare when it comes to IRA decisions. But you probably should.
“There’s an ugly tax that people are assessed in the Medicare program if they’re having to make withdrawals from an IRA,” Clark says.
“You hit that point in your 70s where you have to do what are called Required Minimum Distributions from an IRA.
“And often if somebody’s been a diligent saver and they have a lot of money in an IRA, it’s going to push them into the penalty box where they have to pay much more money to be in Medicare than normal earthlings. There’s no such tax for people who have money in Roths.”
2. Income Tax Brackets
By withdrawing money from a traditional IRA in retirement, you’re increasing your taxable income. That may push you into a higher tax bracket.
“So you have to pay more money for Medicare. And you have to pay higher income taxes,” Clark says.
3. Inheritance
It’s much better to inherit a Roth IRA than a traditional IRA. So if you’re planning to pass along your IRA money to a family member when you die, there’s a clear reason to make the conversion.
If your spouse inherits the IRA, it’s OK. But it’s a “nightmare” if a child or grandchild inherits a traditional IRA.
“The rules are so mean-spirited in how that money has to be taken out, how it’s taxed and all that,” Clark says of traditional IRAs. “It’s like, thanks, grandpa. You could’ve given me something else!
“You know how you look in the side mirror and it says objects are closer than they appear? With a traditional IRA, the net benefit you’re getting when you inherit one is much smaller than it appears because of all the taxes.
“On the other hand, inheriting a Roth IRA by a kid, grandkid, something like that? Awesome thing to inherit. Because every dollar you inherited is a dollar you get.”
Final Thoughts
You probably know that Clark loves Roth IRAs. But if you already have a traditional IRA, don’t feel like that money is stuck. It’s simpler than you may realize to convert a traditional to a Roth IRA. And it can have huge benefits to your financial future in retirement.
