I was breaking a sweat on the treadmill at my favorite gym in Virginia Beach last week (the Hilltop Orange Theory Fitness next to Chick-fil-A, which I definitely didn’t go to afterward) when I overheard some guys expressing dismay about the stock market. Apparently, their portfolios were way down. One guy mentioned he had lost 15% since the beginning of the year. I couldn’t help myself from interjecting. I asked them if they had considered a Roth conversion.
One guy mentioned that he had already lost enough, and he didn’t want to lose even more from a conversion. I would be inclined to agree with him if he was, for example, heading into retirement or 80 years old. But he seemed pretty young still, early 40s perhaps.
Unfortunately, the other fellow hadn’t even heard of a Roth retirement account.
So, I decided it’s high time to spread the gospel of the Roth – its history, its benefits, and when you should consider converting to Roth (if you haven’t already).
The first question we should ask ourselves is not WHAT a Roth is, but WHO Roth is!
Senator William Roth
Senator William Roth was Delaware’s U.S. Senator from 1971 to 2001. Famous as a diehard fiscal conservative, Senator Roth continually battled for lower federal taxes. He was the primary sponsor for what was initially deemed the IRA Plus and later still the Packwood-Roth Plan. Initially, it would have allowed taxpayers to invest up to $2,000, non-deductible. And we’ll get back to what that means later.
In 2006 the Roth IRA’s cousin, the Roth 401(K), was born, combining the power of the Roth IRA with the unique benefits of a company 401(K), such as company matching and higher contribution limits.
What’s the point of the Roth?
The Roth plan allows for post-tax contributions that grow tax-free to and through retirement. More specifically, you pay your taxes as usual and then put funds into your Roth account. When you retire and start pulling from your retirement fund, you don’t have to pay taxes on any withdrawals from your Roth account. For example, if your salary is $80,000 and you only plan on putting into a Roth, you pay your taxes as usual (or set aside the percentage necessary to pay later) and then put $10,000 into Roth. You never have to pay taxes on that $10,000 (or its earnings) ever again, as long as you abide by the IRS rules.
This is in stark contrast to a traditional retirement account, where you don’t pay taxes on any contributions but instead deduct what you put into the account from your tax burden. For example, if your salary is $80,000 and you put $10,000 into a traditional retirement account, you only have to pay income taxes on $70,000 of your salary. You will then pay taxes on that $10,000 in retirement. The catch is you don’t know what your income will look like or what tax brackets there will be.
Just to break things down:
Traditional IRA or 401(K):
- Invest and delay taxation
- Contributions are tax-deductible
- Pay taxes in retirement on contributions and earnings
Roth IRA or Roth 401(K)
- Pay taxes immediately
- Tax-free growth
- Tax-free withdrawals in retirement
Maxing out the Roth
I always recommend maxing out your Roth contributions for a couple of reasons.
We should assume we will be in a higher tax bracket in the future. Taxes are historically low, and it is risky business to assume they will be even lower in retirement. We already know that taxes are going up in 2025. Also, it is difficult to envision what other streams of income we will have in retirement, whether it be from a windfall, a pension, or even Social Security.
Another benefit of maxing out your Roth account is that you will know exactly how much you have when you retire. There won’t be any guessing about how much you owe in taxes and what your retirement income will look like as a result. You can also keep your money invested in Roth forever, unlike a traditional account that requires distributions at the age of 72.5.
One big caveat regarding a Roth conversion – you can’t touch funds for five years after converting, or you risk a 10% early withdrawal penalty. So, if you believe you’ll really need the money within that timeframe, you may want to hold off on a Roth conversion.
With that being said, let’s get back to the original point of when it makes sense to convert.
When does it make sense to convert?
In a Bear Market
The lower the markets are, the more sense it makes. The logic is simple – the smaller your portfolio, the fewer taxes you will pay. Yes, it feels like a blow when you convert, but all future growth will be tax-free. All tax-free earnings will turn into tax-free withdrawals that won’t be counted as income.
Age
The further away you are from retirement, the more it makes sense to convert to Roth – as long as markets are low. This is because the markets will have plenty of time to recover. On the flip side, it doesn’t make sense to convert on the eve of your retirement because there isn’t much time left for the markets to recover. Unfortunately, if stocks are down far enough, you may want to delay retirement because of the Sequence of Returns Risk. Converting to a Roth could be the fatal blow to your portfolio when it’s most vulnerable. You can read more about the Sequence of Returns Risk here.
Future Tax Bracket
If you feel that you will be in a higher tax bracket in the future, it may make sense to convert while in a lower tax bracket. And, as I said before, we should always assume higher taxes in the future. If they’re not higher, excellent. If they are and you haven’t adequately planned for them, you could be in trouble. A conversion may make sense before the TCJA tax cuts expire in 2025, especially while markets are low.
In this article, I’ve given lots of reasons TO convert. Stay tuned for an article about all the reasons why you maybe SHOULDN’T convert. Until then, if you have any questions at all about what a Roth account is or if a conversion is proper for you, please schedule a meeting. It’s simple – just click the button below!
