What to Know About Saving for Retirement and Roth IRA Conversions

Just as I did in an earlier article, I want to focus on the great retirement savings questions I received during a webinar I gave to Morningstar’s women employees. Again, you don’t need to be a woman to benefit from increasing your financial knowledge. Here we go!

Saving for Retirement or Buying a House?

Q: What should come first: a home or a retirement account?

A: Deciding between buying a house and contributing to a 401(k) depends on your personal and financial priorities.

The main benefits of buying a home are:

• Equity growth.
• Relief from the uncertainty of rent.
• Ability to deduct mortgage interest.

The main benefits of contributing to a 401(k) are:

• Compound growth of retirement savings.
• Employer match.
• Tax-deductible contributions.

Assuming you don’t have ongoing credit card debt (in which case, that should be the priority), your main focus should be on contributing enough to your 401(k) to get the full employer match (if offered). It’s free money—something you shouldn’t forgo.

Once you’ve done that, it’s time to think about buying a house. But there are a lot of factors to consider. The preliminary factors are:

• The amount of money you have accumulated toward a down payment (and a cash cushion for emergencies).
• The amount required for a down payment based on the type of loan you will use.
• Interest rates and the anticipated monthly payment.
• Your financial and personal readiness.

Before deciding to buy a house, you will need to weigh all of the advantages and disadvantages. You should consult with a qualified financial planner. You should look for a registered investment advisor who is fee-only—and preferably, one who will only charge for helping you with planning. A good resource is The National Association of Personal Financial Advisors.

Converting to a Roth IRA

Q: Do you have any recommended strategies for converting traditional IRA assets to Roth IRA assets on an ongoing basis? We’re trying to avoid getting hit with large RMDs in the future.

A: Great question! Many workers who have been diligent about making maximum 401(k) contributions are surprised by the hefty accumulated balance once they retire. Of course, it’s great to have a big 401(k) account. You can roll it into an IRA at retirement, and let it continue to grow tax-deferred. Unfortunately, once you reach age 72 (or 73 or 75, depending on your birth date), you’ll have to take required minimum distributions. Because the RMDs are based on the total balance, these distributions could push you into a high tax bracket, causing your savings to decline faster than you’d like.

If you convert some or all of your IRA to a Roth IRA, there will never be future tax on the Roth distributions or the earnings. The catch is you must pay tax on the amount converted right away.

Typically, the years between retirement and age 72 (or 73 or 75) produce lower taxable income. In fact, the period between retirement and collecting Social Security are usually the lowest income years. During this time, you will likely be in very low tax bracket, and it will make sense to do Roth conversions to the extent it won’t put you in a higher tax bracket. In some cases when income is very low, it could be possible to do some Roth conversions without paying any tax!

If you do Roth conversions every year prior to when RMDs kick in, your RMDs will be much lower, as will your tax bracket—and you’ll have a pool of tax-free money to draw from as needed.

In general, here are the pros and cons of Roth conversions.

In favor of conversion:

• You don’t need to pay the conversion taxes from the IRA.
• You expect to be in a higher tax bracket when you take RMDs.
• Tax rates are expected to increase in the future.
• You will not be reliant on full RMDs for living expenses.
• Your family might inherit your IRA.

Against conversion:

• Conversion taxes will need to be paid from the IRA.
• You expect to be in a lower tax bracket when you take RMDs.
• You will be reliant on full RMDs for living expenses.
• You don’t want to pay taxes early, even if it’s “at a discount.”
• Your IRA will be bequeathed to a charity.

Determining the right amount to convert can be daunting. Be sure to consult with a qualified tax professional.

Q: Are Roth conversions taxed on a first in, first out basis?

A: Actually, funds in a Roth are not taxed. That’s the big benefit. The funds you contribute to a Roth are aftertax, and conversions are taxed upfront. Then, when you take withdrawals, there’s no tax. The only exception is if you withdraw earnings before five years since the year of the related conversion. The earnings withdrawn will be subject to ordinary tax. The withdrawals will be deemed to be taken on a FIFO basis.

So, let’s say you did a Roth conversion each year beginning in 2020 in the amount of $20,000. In early 2024, the Roth account has a balance of $92,000. If you take $50,000 out, there will be no tax. If you take $85,000, $5,000 will be taxed—the amount greater than the principal contributed of $80,000.

Q: Can couples lower their modified adjusted gross income to qualify to contribute to Roth IRAs?

A: First, let’s look at the Roth contribution rules. Contributions to an IRA (or Roth IRA) are limited to the lesser of your earned income or $7,000 ($8,000 if you are 50 or older). Your option to make a Roth contribution is further limited if your modified adjusted gross income, or MAGI, is above certain levels. For example, you cannot make a Roth contribution at all if your MAGI is greater than $161,000 if you’re single or $240,000 if you’re married.

MAGI is adjusted gross income modified by adjusting certain income, deductions, and credits, such as:

• Add back student loan interest deductions.
• Add back tuition and fees deductions.
• Add back deductions for 50% of self-employment tax.
• Add back rental losses.
• Other miscellaneous adjustments.

To answer your question, you can lower your MAGI in several ways. Consider increasing 401(k) and flexible spending account contributions, opting for deferred compensation (if your employer offers it), or switching from taxable bonds and savings accounts to tax-exempt bonds. If you can’t qualify for Roth, consider making a nondeductible IRA contribution. Your CPA can help with calculations and planning ideas.

Retirement savings tax rules and financial implications are complicated. Because of this, you should consult with qualified professionals in the areas of tax (look for a CPA) and financial planning (a registered investment advisor).