A Roth conversion means moving money from a traditional IRA into a Roth IRA, paying taxes on that money now in the hope of saving tax costs later. While nobody likes paying taxes before they need to, there are several reasons a Roth conversion may make sense as part of a financial plan.
First, a reminder about the two types of individual retirement accounts and how they work: A traditional IRA includes funds that were deducted from income when they were contributed to the account, and distributions from a traditional IRA are then counted as income and taxed when the funds are distributed. The funds in a Roth IRA were contributed after–tax and not deducted from income, but qualified distributions are generally tax–free during retirement (more on what makes a distribution qualify for tax–free treatment in a minute). Another important difference between a traditional IRA and a Roth IRA is that a traditional IRA will have mandatory taxable distributions beginning at age 72, and the size of those distributions is based on the owner’s age and the annual account balance. Roth IRAs, unless they are inherited, do not have mandatory distributions.
While there are income limits that determine who can contribute to a Roth, there are no restrictions on income levels or limits when converting funds from a traditional IRA to a Roth IRA. Anyone with a traditional, pre-tax IRA can move all or a portion of the funds to a Roth IRA so long as they are willing to pay the taxes when they make the conversion.
When does a Roth IRA conversion make sense?
· If an IRA owner is in a lower tax bracket during a particular year, and expects their taxes will be higher later, converting a traditional IRA to a Roth IRA can be a means of taking advantage of that situation. The key is determining how much money can be converted before the increased income increases the tax rates. For instance, if someone is in the 12% tax bracket and can take another $10,000 before reaching the 22% tax bracket, that would be a good potential Roth conversion amount. A word of caution: tax projections are not as simple as just reviewing marginal tax rates. Increased income can affect other things as well, such as eligibility for certain other tax incentives, capital gains rates, and the taxability of Social Security. Look at the big picture before arriving at a conclusion.
· If an IRA owner has a large enough traditional IRA balance, their future Required Minimum Distributions may be more than they need to spend and could throw them into a higher tax bracket. Roth conversions prior to age 72 can be a useful tool to aid this situation. Since mandatory distributions, and the taxes they create, are based on the annual account value, moving funds out of the traditional IRA and into Roth means lowering those required distributions. There is often an opportunity for this technique when someone retires in their 60s and has sources of income outside the IRA for a few years before reaching age 72. Again, a tax projection is necessary to see how to spread the conversion over several years. Rarely does it make sense to move all IRA funds to Roth in one year.
· If an IRA owner is not likely to spend all their IRA during their lifetime and is likely in a lower tax bracket than their beneficiaries, converting some or all of the traditional IRA to Roth IRA during their lifetimes makes the inherited account more valuable to the heirs because the taxes are pre-paid. Non-spouse beneficiaries need to take funds out of either inherited traditional IRA or inherited Roth IRA within ten years, but the traditional IRA funds will be taxable at their marginal rate while the Roth IRA distributions may be tax-free.
· Some IRA owners leave IRA assets to non-profits instead of individuals. Since 501c – 3 charities don’t pay income tax, Roth conversions for those funds generally do not make sense. It is better to leave traditional, pre-tax IRA assets to charities and reserve Roth assets, which will pass tax–free, to individuals.
The mechanics of doing a Roth conversion are generally simple:
- Open a Roth IRA at the custodian that holds the traditional IRA.
- The custodian will have a form to complete that authorizes them to move the funds from the traditional IRA to the Roth IRA.
- One option on these forms is whether to withhold taxes on the conversion. Generally, we advise not withholding taxes on the transaction but instead covering taxes from an outside source whenever possible. Covering the taxes from savings means that more of the converted money remains in the Roth, growing tax–free. However, the withholding discussion should be part of the tax projection, and we coordinate this with the client’s tax professional as often the tax liability needs to be covered in an estimated tax payment if it is not covered by withholding.
- We normally wait until the end of the year to do Roth conversions so we have a good feel for the complete tax picture and can more accurately project the correct amount to convert.
Once the conversion is complete
Roth IRA qualified distributions are tax-free with no mandatory distributions. To be a qualified distribution from a Roth IRA, the account owner must be over 59 ½ years old and have had a Roth IRA for five years, whichever is later. Note that the five-year calendar starts with the first Roth IRA established by the owner and doesn’t re-start for each contribution and doesn’t have to be the same account or at the same custodian. Unless certain exceptions apply, the growth portion of any non–qualified distributions is taxed as income. The contributions and conversion amounts in a Roth have already been taxed and can be withdrawn at any time without being taxed again.
If you would like more information on converting a Roth IRA account please contact us. We’d be happy to answer your questions.
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