Roth Vs. Traditional Ira Contributions: Would a Roth Conversion Be Right for You?

It is extremely important to start planning for retirement as early as possible. Not only should you decide how much to contribute (the general rule of thumb is that you should save around 15% of your gross income for retirement), but you should also consider which type of accounts you are contributing to. Depending on your personal situation and the particular stage of your career, it may be best for you to contribute to one type of account vs the other. Roth conversions and backdoor Roth contributions are two additional aspects of retirement planning to consider.

First, let’s go over the basics of each type of IRA. Depending on your income and whether you and/or your spouse are covered by a retirement plan at work, a traditional IRA allows you to make tax-deductible contributions. You receive a deduction in the year of contribution, but the withdrawals will be taxed later on. These are known as tax-deferred contributions. If your income is too high to take the deduction, then you can still make a non-deductible contribution to your traditional IRA account. A non-deductible contribution gives you basis in your traditional IRA since you did not receive a deduction for the contribution. Due to this, a portion of your withdrawal will not be taxable. The amount of the withdrawal that is taxable depends on the aggregated value and basis amounts in all of your traditional IRAs. On the other hand, you do not receive a deduction for contributions to a Roth IRA. However, the withdrawals are tax-free, and there are no required minimum distribution requirements, meaning that you can withdraw as much or as little as you like during retirement. You can also leave your Roth IRAs to your beneficiaries as part of your estate plan. Contributions to a Roth are also limited or even disallowed if your income is above a certain level. But even if your income is too high to make a direct contribution to a Roth IRA, you can still make a Roth conversion or a backdoor Roth contribution, which I will go over in more detail later on.

Now that we’ve gone over the basics let’s discuss why you should consider which type of account to contribute to. Everyone’s circumstances are different, and you need to consider all aspects of your financial situation in order to make the right decision. But generally speaking, it is better to contribute to your traditional IRA during years of higher income. This is true for two reasons. First, you receive a tax deferral during a year when your tax rate is higher. Later on, if your income is lower during retirement, you will pay a lower tax rate on the withdrawal. Also, your income may be too high to contribute to Roth during these high-income years. This strategy assumes you are not covered by a retirement plan at work. If neither you nor your spouse are covered by a retirement plan at work, then you will receive a full deduction for your traditional IRA contributions, no matter how high your income is. If you or your spouse are covered by a retirement plan at work, your deduction may be limited or completely disallowed. In this case, you should still make sure to contribute as much as possible to your employer-sponsored plan, at least enough to get the employer match since it is basically free money. If you have any money left over to put towards retirement, you should contribute to a Roth IRA to the extent that you are not able to receive a deduction for a traditional IRA contribution. Conversely, it is generally better to contribute to a Roth IRA earlier in your career when you have a lower income. The tax deferral isn’t as valuable during this time period because your effective income tax rate is lower. Additionally, contributing to a Roth as early as possible is beneficial because the investment has more years to grow, and the subsequent withdrawal will be tax-free. Depending on your situation during retirement, your Medicare premiums and taxable amount of Social Security may also be reduced by taking tax-free withdrawals from your IRA. Another reason to implement this strategy is that your income may be too high to make a direct Roth contribution later in your career.

Fortunately, even if your income is too high to make a direct contribution to a Roth IRA, you can still contribute money to a Roth IRA with either a Roth conversion or a backdoor Roth contribution. A Roth conversion is where you convert some or all of your traditional IRA balance(s) into a Roth IRA. There is no limit on the amount that you can convert, but you have to pay tax on the conversion. As I mentioned before, the taxable amount of the conversion is dependent upon the basis and value amount(s) of all your traditional IRAs. As an example, let’s assume you have just one traditional IRA with a value of $50,000 and a basis amount of $20,000 as a result of non-deductible contributions you made in the past. You can convert any amount up to the total value of the traditional IRA, and 60% of that conversion would be taxable. So, if you choose to convert $20,000 of the traditional IRA to a Roth IRA, you would have an additional $12,000 in ordinary income on which you would have to pay tax. If you have multiple traditional IRAs, the same rules apply, but no matter which traditional IRA(s) you choose to convert, the taxable amount of the conversion is calculated based on the aggregate value and basis amounts of all your traditional IRAs. This rule is meant to keep you from choosing to convert just your IRA(s) with higher basis amounts in an effort to lower the taxable amount of the conversion. Roth conversions can be especially beneficial after a downturn in the market. By converting after your traditional IRA has lost value, there will be less of a tax burden, and the subsequent gains will be tax-free since those funds are now in a Roth account. It is also important to note that you are not required to have earned income in order to perform a Roth conversion; you can have multiple conversions in a single year, and again, there is no income limit on being able to make a conversion. Similar to a Roth conversion, a backdoor Roth contribution is where you make a non-deductible contribution to a traditional IRA, immediately make a withdrawal, and then contribute that withdrawal into a Roth IRA. This strategy works best when you have only one traditional IRA account that is used solely as a conduit for making a backdoor Roth contribution.

In summary, after considering your career path, as well as your tax and financial circumstances it is important to think about the different aspects of IRAs and employer-sponsored plans when developing a strategy for retirement planning. If you would like to discuss these issues more specifically as they relate to your particular situation, please schedule a free consultation so that we can make sure you’re choosing the proper course of action.