Financial planning for stay at home moms: roth conversions
What should Stay at Home Moms do with old 401ks?
Stay at Home Moms are in a unique spot, financially. They are not “earning” a paycheck, but they contributed financially to their household in the past and are now contributing to their household in a different way.
It is important for Stay at Home Moms to not put their personal finances on the back burner just because they are not earning a paycheck.
This is part 2 of my Financial Planning for Stay at Home Moms Series. In this blog post, we will discuss Roth Conversions for the Stay at Home Parent and why converting a Stay at Home Moms’ old 401k(s) to a Roth IRA could be a beneficial move for their retirement.
In Part 1, we discussed Spousal IRAs and the importance of retirement planning for Stay at Home Moms.
Financial planning for stay at home moms: unique planning opportunities
I am a Financial Advisor for young and millennial families, I help families remove the emotions when it comes to their household finances and look at the pros and cons of every financial decision they are going to make. And when emotions are removed we can implement some unique financial planning strategies
For example, when one parent transitions to staying at home, eliminating one income from a house creates less money for your family to live on (a con), but having one income also presents a unique retirement planning strategy that may have not been an option if there were dual incomes (a pro).
The financial planning strategy for single incomes families is converting your traditional 401k or IRA to a Roth IRA.
*Please note that I am saying Stay at Home Moms, but this can also work for Stay at Home Dads and single income families.
Financial Planning for Stay at Home Moms: Becoming a one income household
The Center for American Progress now estimates that the true cost of putting your child in daycare is over $16,000 per year. Sounds expensive, doesn’t it? “I’m working just to pay for daycare” is a common phrase for many parents.
For some families, it makes more sense for a parent to stay home and manage the household instead of holding a full-time job, especially when there’s more than one child that would be in daycare.
Families should look at the transition from dual-income to single income as a unique time for financial planning. (link to services page)
Regardless of if one parent is reducing their work hours to part-time or fully transitioning out of the workforce for a short period, it’s important to analyze the potential benefits of a retirement conversion if your income is lower now than it traditionally has been in the past or will be in the future.
Once you decide to transition one parent to a homemaker role, there are financial considerations beside daycare costs to keep in mind. The biggest consideration is that your household will go from two incomes down to single income. Will your household budget allow for one parent to stop earning a paycheck?
What should Stay at home moms do with their old 401k?
You have now made the decision to transition from working outside the home to working solely in your home and managing your household. You have left your employer, which also means you left your 401k as well. Now that SAHMs are busy focusing on their children, they often stop thinking about their retirement.
Even though you are no longer working doesn’t mean you should stop paying attention to your retirement account. Yes, our focus has shifted to planning day-by-day from planning for the future. Your job now is caring for your children and managing your household, but you’re still going to retire one day and we want to make sure you’re prepared. So, don’t leave your old 401k behind.
At a minimum, roll your previous employer’s 401k into an IRA. If you have a couple of previous employers with respective 401ks, consolidate all of them into one IRA. Getting one statement in the mail and keeping track of one account versus four makes your life easier, right?
Now that all your 401ks are in one place, it may be advantageous to consider a Roth conversion for at least part of your retirement account.
Financial Planning for Stay at Home Moms: Convert your old 401k to a Roth IRA
Before making any changes though, you need to understand the benefits of converting a 401k or IRA to a Roth IRA, what factors stay at home spouses should consider, and the basics of the conversion process.
Financial Planning for Stay at Home Moms – What is better: Roth or Traditional IRA?
I often get asked by clients if they should contribute to an IRA instead of a Roth or vice versa or what is better? I can say that both have pros and cons and all factors should be considered. The rule of thumb I like to use is: those that contribute (or convert) to a Roth believe that taxes are lower now than they will be during their retirement.
Keep in mind that even if your income is going to be lower in retirement, you may still be in a higher tax bracket, or pay a higher tax rate due to legislation at that time. So, the thinking is you pay taxes now for the benefit of not having to pay taxes again on that money.
Traditional IRAs are the opposite. You reduce your income today, potentially pay less taxes now, and defer taxes until you start taking withdrawals and then taxes are paid on the withdrawn amount.
But, in any case, tax free income in retirement is fantastic.
Can Stay at Home Moms contribute to a Roth?
Contributions to Roth IRAs do have some limitations, like traditional IRAs. If you are under 50 years old, in 2023, you can only contribute $6,000 a year. If you’re older than 50, you can contribute the $6,000 plus an extra $1,000 “catch-up” contribution.
If your household makes “too much” money, you are unable to contribute to a Roth. Traditional IRAs do not have income limitations.
Another benefit of having a single income household is that additional income may have bumped your household up into that “too much” category. To contribute to a Roth IRA, if you’re married and file jointly, your MAGI must be under $214,000 for tax year 2022 and $228,000 for tax year 2023. If your income is above those numbers you make “too much” and can’t directly contribute to a Roth, but there are no income limitations for Roth Conversions. A SAHM also needs earned income to contribute to a Roth. You can only contribute to a Roth, what you earned in income for the year and unlike a traditional IRA, Roth IRAs are not tax deductible. For example, if your earned income was $4,000, the maximum you can contribute to a Roth IRA is $4,000.
Earned income does not include:
- Rental income or other profits from property maintenance
- Interest income
- Pension or annuity income
- Stock dividends and capital gains
If a SAHM does not have earned income, that is where a Spousal IRA that I talked about in part 1 of this series becomes a tool to utilize for retirement savings.
What Should Stay at Home Moms do with old 401k? – Why would a SAHM want to do a Roth Conversion?
There are a few different reasons why families may decide to convert a 401k or IRA to a Roth IRA.
The first benefit is tax-free growth potential.
Since you paid tax on the funds once they were converted, any future growth on the account will be tax-free when you withdraw the funds.
If all of your and your spouse’s retirement dollars will have to be taxed in retirement, it limits the flexibility you have when you reach retirement. What if you were to retire and tax rates are high? You have no choice but to make your withdrawals to live off of and pay taxes.
But, if a portion of your retirement dollars were Roth, you could have some tax-free income in retirement.
In addition, moving funds to a Roth IRA eliminates the required minimum distribution requirement (RMD).
RMDs mandate how much money individuals must use from their retirement accounts after reaching a specified age by the government (72 in 2022, 73 in 2023).
By avoiding this requirement, you can leave more money to your heirs and help ensure you don’t outlive your retirement funds.
Recent studies show that nearly 51% of retirees believe they will outlive their retirement funds.
Additionally, Roth IRAs allow you to withdraw the amounts you contribute before you reach age 59 ½ without any penalties.
This is beneficial if you retire early or need extra funds. However, you can only withdraw the amounts you contribute and not any of the earnings without incurring an early withdrawal penalty. For example, if you contribute $100,000 to a Roth IRA, but the account value is now at $150,000, you can only withdraw the initial $100,000 without incurring any penalties.
Roth IRAs can be used to pay for college
Parents who find they need some extra cash to pay for college tuition could turn to their Roth IRA to help them. Parents who withdraw their Roth earnings for college will have to pay income taxes on the amount they withdraw (above their contribution amount) but they can avoid any penalties.
What Factors Should Stay at Home Spouses Consider?
Families with a stay at home parent should consider the following factors when deciding if a Roth conversion is the right move.
Lower Household Income
Oftentimes the household income will drop when the family shifts one person to the homemaker role.
This presents an opportunity to make a Roth conversion from a traditional Roth 401k or IRA and pay less taxes. Since the US tax system works based on marginal brackets, once your income drops, your tax bracket does as well. This can push you into a lower tax bracket, ultimately resulting in a lower tax liability on the conversion compared to holding the funds until retirement.
Market Downturns
Market downturns also present a unique opportunity for families with a stay at home parent. When the market is down, meaning stock values are lower, the funds in your 401k or IRA will be less compared to if the market is booming. When you convert the funds in your retirement accounts to a Roth IRA at the low point, you will be assessed less taxes since the dollar amount you’re converting is lower.
Future Plans
Families should also consider future plans. If one spouse is staying at home temporarily, now might be the right opportunity to make the conversion before you have two incomes pushing you into a higher tax bracket. You want to take advantage of the lower taxes you’re paying currently and potentially convert to a Roth before your household because dual income again.
Tax Due
Although a Roth conversion might sound good on paper, you also should consider the tax implications of the transaction. Your tax bracket and amount converted will impact how much tax is going to be due. Many families choose to pay the tax due directly out of the converted retirement funds. Keep in mind that this will lower your growth potential, making it important to consider the implication of taxation.
A better idea may be to pay the taxes due out of savings. But this then lowers the amount your household has saved in cash.
Could you make adjustments to pay back that savings account in a reasonable amount of time?
