If it's the last week of the month, odds are Alison Southwick and Robert Brokamp are going to amble over to the Motley Fool Answers mailbag to find out what it is their listeners really want to know. And for added gravitas and expertise, they've brought in reinforcements: Naima Barnes, a financial planner with Motley Fool Wealth Management, a sister company of The Motley Fool.
In this segment of the podcast, they tackle one of the fundamental questions about Roth IRA conversions, which is: Why would you want to do one in the first place? In large measure, the answer comes down to taxes -- when you'll pay them, and how much.
Naima Barnes is an employee of Motley Fool Wealth Management, a separate, sister company of The Motley Fool, LLC. The information provided is intended to be educational only, and should not be construed as individualized advice. For individualized advice, please consult a financial professional.
A full transcript follows the video.
This video was recorded on May 29, 2018.
Alison Southwick: Let's get into it. Our first question comes from the Twitters. The question is, "If the conversion of funds from a traditional IRA to a Roth IRA is counted as income and taxed, then what is the benefit of doing this?"
Robert Brokamp: So, whenever you convert money that's in a traditional account to a Roth, that amount gets added to your taxable income. If you convert $10,000 you have to add that $10,000 to your income, so you're going to pay more taxes this year. The benefit is that ideally you are in a lower tax bracket this year and you'll be in a higher tax bracket in retirement. Basically, you're paying taxes today, or prepaying them, really, at a low rate so that you can get a better benefit when you retire.
There are all kinds of calculators on the internet that will help you analyze the situation. I found one at calcxml.com. Just very quickly a little hypothetical, here. Let's say you're 35 and you're in the 12% tax bracket today. You convert that $10,000 to a Roth. Let's say you're in the 22% tax bracket in retirement. What's the difference? Well, if you do the conversion, that account will provide $8,700 a year in retirement. If you don't do the conversion on an after-tax basis, the traditional IRA will just provide $7,500 a year. You're getting more than $1,200 a year in after-tax income by doing the conversion.
Obviously, this takes some assumptions. You don't really know what the future's going to look like, so there are other reasons to do a conversion. One is a traditional IRA or 401(k), you have to take out required minimum distributions at age 70 and a half. The Roth IRA, you do not, so that's another benefit. You can let that money grow a little longer.
Also, it gives you what's called tax diversification. When you're in retirement, if you have a year in which you have high taxes for any reason [maybe you got a lump sum investment of some kind, a big capital gain], you can tap the Roth, then, to counteract being driven up even higher into a higher tax bracket.
One word of caution, though, is let's say you're in a low tax bracket today and you decide that the conversion makes sense. When you do the conversion, that money gets added to your taxable income which could drive you up into a higher tax bracket, so you only want to convert so much so that you stay in the current tax bracket and not get driven up into the next one.