A Roth account is a type of retirement account that allows you to save money with after-tax dollars and enjoy tax-free withdrawals in the future. There are two main types of Roth accounts: Roth IRA and Roth 401(k). Both have their own rules and benefits, but the main difference is that a Roth IRA is an individual account that you open on your own, while a Roth 401(k) is an employer-sponsored plan that you participate in through your work.
One of the advantages of a Roth account is that you can avoid paying taxes on the growth of your investments, as well as on the withdrawals you make after age 59½, as long as you meet certain requirements. This can be especially beneficial if you expect to be in a higher tax bracket in retirement than you are now, or if you want to have more flexibility and control over your income sources in retirement.
However, not everyone can contribute to a Roth account directly. There are income limits that restrict who can make regular contributions to a Roth IRA or a Roth 401(k). For 2023, the income limits are $153,000 for single filers and $228,000 for married couples filing jointly for a Roth IRA, and $208,000 for single filers and $312,000 for married couples filing jointly for a Roth 401(k). These limits are adjusted annually for inflation.
If you earn more than these limits, you may still be able to move some money to a Roth account through a process called a conversion. A conversion is when you transfer money from a traditional account, such as a traditional IRA or a traditional 401(k), to a Roth account. A traditional account is funded with pre-tax dollars, which means that you get a tax deduction for your contributions, but you have to pay taxes on your withdrawals in retirement.
When you convert money from a traditional account to a Roth account, you have to pay taxes on the amount you convert, based on your marginal tax rate in the year of the conversion. This can be a significant cost, depending on how much you convert and what your tax situation is. However, once you pay the taxes, the money in your Roth account can grow and be withdrawn tax-free, as long as you follow the rules.
So, how much should you move to a Roth account? There is no definitive answer to this question, as it depends on many factors, such as your current and future income, your tax rate, your expected retirement expenses, your time horizon, your risk tolerance, and your personal preferences. However, here are some general guidelines that can help you make an informed decision:
- Consider your tax diversification. Tax diversification is the idea of having different types of accounts that are taxed differently, such as pre-tax, after-tax, and tax-free. This can help you reduce your overall tax burden and have more options in retirement. Ideally, you want to have a balance of different types of accounts, so that you can choose the most tax-efficient way to withdraw your money in retirement. For example, if you have mostly pre-tax accounts, such as traditional IRAs and 401(k)s, you may want to move some money to a Roth account to create some tax-free income in retirement. On the other hand, if you have mostly after-tax accounts, such as taxable brokerage accounts, you may not need to move much money to a Roth account, as you already have access to tax-efficient income sources in retirement.
- Consider your tax bracket. Your tax bracket is the percentage of tax that you pay on your income, based on your filing status and income level. Generally, the higher your income, the higher your tax bracket. When you convert money from a traditional account to a Roth account, you have to pay taxes on the amount you convert at your marginal tax rate, which is the tax rate that applies to your last dollar of income. Therefore, you want to convert money when your marginal tax rate is low, and avoid converting money when your marginal tax rate is high. For example, if you expect your income to be lower in a certain year, such as when you have a job loss, a career change, or a large deduction, you may want to take advantage of the lower tax rate and convert some money to a Roth account. On the other hand, if you expect your income to be higher in a certain year, such as when you have a bonus, a raise, or a capital gain, you may want to postpone the conversion and wait for a better opportunity.
- Consider your time horizon. Your time horizon is the length of time that you plan to keep your money invested before you need to withdraw it. Generally, the longer your time horizon, the more beneficial a Roth account can be, as you have more time to enjoy the tax-free growth and compounding of your investments. However, if your time horizon is short, such as less than five years, you may not benefit much from a Roth account, as you have to pay taxes upfront and may not have enough time to recover the cost. Therefore, you want to convert money that you don’t need to access in the near future, and leave money that you may need to access soon in a traditional account.
- Consider your conversion strategy. Your conversion strategy is the way that you plan to move money from a traditional account to a Roth account. There are different ways to do this, such as converting a lump sum, converting a fixed amount, converting a percentage, or converting based on a formula. Each method has its own pros and cons, and you should choose the one that suits your goals and circumstances. For example, if you want to simplify your conversion process and pay the taxes once, you may want to convert a lump sum. However, this may also increase your tax bill and push you into a higher tax bracket. On the other hand, if you want to spread out your conversion and pay the taxes over time, you may want to convert a fixed amount, a percentage, or a formula. However, this may also increase your complexity and uncertainty, as you have to monitor your income and tax situation every year.
Here is a table that summarizes some of the pros and cons of different conversion methods:
| Conversion Method | Pros | Cons |
|---|---|---|
| Lump sum | Simple and easy | High tax bill and tax bracket |
| Fixed amount | Predictable and consistent | May not optimize tax efficiency |
| Percentage | Adjusts to market fluctuations | May not align with income changes |
| Formula | Customized and flexible | Complex and uncertain |
To illustrate how different conversion methods can affect your taxes and your Roth account balance, let’s look at an example. Suppose you have $100,000 in a traditional IRA and you want to convert it to a Roth IRA over 10 years. You are in the 22% tax bracket and you expect to stay in the same bracket for the next 10 years. You also assume that your investments grow at an average annual rate of 7%. Here is how much you would pay in taxes and how much you would have in your Roth IRA after 10 years, depending on the conversion method you choose:
| Conversion Method | Taxes Paid | Roth IRA Balance |
|---|---|---|
| Lump sum | $22,000 | $196,715 |
| Fixed amount | $22,000 | $196,715 |
| Percentage | $22,000 | $196,715 |
| Formula | $22,000 | $196,715 |
As you can see, in this example, all four methods result in the same amount of taxes paid and the same Roth IRA balance after 10 years. This is because the tax rate, the growth rate, and the conversion period are constant. However, in reality, these factors may vary, and different methods may produce different outcomes. Therefore, you should always run the numbers and compare the results before choosing a conversion method.
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