Traditional IRAs have been available to retirement savers who have earned income since 1974. That’s 23 years longer than Roth IRAs (introduced in 1997) have been on the scene. The big difference between these two types of individual retirement savings vehicles is when you pay federal (and possibly state) income tax on your savings.
With a traditional IRA, if your income is below certain levels, you make pre-tax contributions to your IRA (that you may be able to deduct) and pay your taxes when you withdraw that money after retirement, possibly at a time when you are in a lower tax bracket. You’re paying those taxes on both your contributions and the earnings on those contributions. With a Roth IRA, you contribute already taxed money to the IRA and, if your withdrawals are qualified, you pay no taxes at the time of withdrawal.
The above paragraph needs some additional detail before we delve into the topic of this article, which is Roth conversions.
Explanation 1: With a traditional IRA, if your income is at or above certain levels, your contributions must come from already taxed money, though the earnings don’t get taxed until the time of withdrawal.
Explanation 2: In a Roth IRA, if your withdrawals are not qualified, you will pay taxes on your earnings at the time of withdrawal. You already paid taxes on your contributions. For a Roth withdrawal to be considered qualified, you must have had a Roth IRA for at least 5 years, and you must be age 59 ½ or older at the time of the withdrawal.
Explanation 3: An individual with income above a certain level is not allowed to contribute to a Roth IRA – at all. For 2021, the modified adjusted gross income threshold for individuals is $140,000, and for joint filing it’s $208,000. However, you can still convert IRA monies to Roth if above those thresholds. (Note: A TSP cannot be directly converted to a Roth TSP, you’d have to rollover your TSP to an IRA, and then convert the IRA to a Roth IRA, as discussed in this article.)
Those of us who began our retirement savings prior to the introduction of the Roth, or who had incomes too high to allow us to contribute to a Roth, might want to move more of our retirement savings from traditional IRAs, where we pay taxes at withdrawal, to Roth IRAs, where we pay taxes up front, but benefit from tax free growth. Well, we can do that by means of a Roth IRA conversion.
A Roth conversion lets you move monies from your traditional IRA into a new or existing Roth IRA. There are no income limits, or limits on the amount that can be converted, though you must pay tax on all untaxed monies that you convert. This would mean that, if you converted money from a traditional IRA where you were able to deduct your contributions, you would pay tax on every dollar you converted; and if you converted money from a traditional IRA where you were not able to deduct your contributions, you would pay tax on the amount of the conversion that was attributable to earnings. The taxes would be at your rate for ordinary income.
Here are some things to consider before you decide to convert money from a traditional IRA to a Roth IRA.
• When will you need the money? If you have an immediate need for the funds or need them to support your current standard of living, then a Roth conversion is probably not for you. However, if you have no immediate need for the funds, a Roth conversion can be a great way for your money to grow tax-free over your lifetime.
• Where will the money come from to pay the tax? In nearly all cases, the money to pay the tax on the Roth conversion should come from outside funds (i.e., not from a retirement account) in order for the conversion to make sense. When a conversion is made it almost always triggers a taxable event, so your ability to pay that tax with outside money will go a long way in determining if a Roth conversion is right for you.
• What do you think future tax rates will be? If you believe your income tax rate will be the same or higher in retirement, then converting funds to a Roth makes sense because you will be paying your taxes at a lower rate. However, if you think your income tax rate will be lower in retirement, perhaps conversion is not for you.
• Other reasons to consider a conversion.
• You might be in a favorable tax situation (e.g., large deductions, tax losses, tax credits, etc.) in the year you convert, putting more of the taxes you owe in a lower marginal bracket.
• You do not have to take required minimum distributions (which begin at age 72) from a Roth IRA.
• You can provide an income-tax free inheritance to your heirs.
• Other reasons to not consider a conversion.
• You have an aversion to paying taxes up front.
• You don’t trust the government to keep its promise of tax free growth in a Roth.
• You plan on naming a charity (that won’t have to pay any taxes on your bequest) as your Roth IRA beneficiary.
• If you change your mind, you are not allowed to undo (recharacterize) a Roth conversion.
This article talked specifically about Individual Retirement Arrangements. However, we should remember that we are allowed to convert money from our TSP (both traditional and Roth) to a Roth IRA under specific circumstances.