retirement planning | october 13, 2020
Roth Conversion: Is it Right for You?
Moving assets to a Roth IRA can provide more income flexibility in retirement.
A Roth conversion could be especially beneficial if you expect to be in a higher tax bracket in retirement.
With a Roth conversion, taxes are due on the converted amount in the year of the transaction.
There are different ways to cover these taxes, each with its own tax implications.
Roger Young, CFP®
Senior Financial Planner
There is a fairly simple financial move that can create significant advantages for many investors: converting a Traditional individual retirement account (IRA) to a Roth IRA. While it may not be the right choice for everyone, Roth conversions can provide tax diversification and help many investors increase their future financial flexibility in retirement. Every investor may want to consider gaining some exposure to Roth IRAs. For retirees, having a Roth IRA can increase their after-tax income, since qualified withdrawals from the account are income tax-free.*
There are a number of benefits to owning a Roth IRA. The trade-off is that moving assets from a Traditional IRA to a Roth IRA generally requires paying taxes at the time of the conversion rather than later, when you start taking withdrawals.
Deciding whether to convert assets to a Roth IRA depends largely on what you anticipate your future income tax bracket will be. The conversion could be especially beneficial if you expect to be in a higher tax bracket in retirement—you’ll pay the taxes now at your lower current rate. That said, the move may be advantageous, in some cases, if you think your tax rate will stay the same or decline—for example, if your beneficiaries could be in higher tax brackets. Having tax-free Roth assets can provide you with freedom to use that money to pay for expenses in retirement, such as a new roof or a special vacation, without increasing your annual taxable income. Conversely, if you used money from your Traditional IRA to pay for those expenses, those assets would be included in your taxable income and potentially could increase your marginal tax rate as well as your Medicare premiums.
Additionally, Roth IRAs do not have required minimum distributions (RMDs) for the original owner, which make them a valuable retirement and estate planning tool. If you don’t need to make withdrawals during retirement, you can leave those assets—and any tax-free earnings they generate—to your heirs. The amount you pass on to heirs can continue to grow tax-deferred in their Inherited Roth IRAs. Your heirs will be required to take RMDs each year, and they can always withdraw more whenever they need it. Leaving a Roth IRA to a beneficiary is one way to generate potentially tax-free income for your loved one. Due to the passing of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, beneficiaries of retirement accounts now generally need to withdraw all of the funds within 10 years, with some exceptions. This can increase a beneficiary’s tax rate, which makes inheriting Roth assets appealing.
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The Cost of Conversion
Before converting, consider each of the following strategies for paying the taxes.
Stagger the conversion. If a Roth IRA conversion would push you into a higher federal tax bracket, consider conducting partial conversions over multiple years.
Generally speaking, it’s ideal to pay taxes on the conversion from a taxable account. This method may have the smallest tax consequences.
If you don’t have enough savings in a taxable account to pay the taxes, consider taking a tax-free withdrawal from an existing Roth IRA. Note that for those under age 59½, only contributions can be taken tax-free. Generally, if you’re age 59½ or older and have held the account for at least five years, however, you can take tax-free withdrawals of both contributions and earnings.
If neither a taxable account nor an existing Roth IRA is available to pay the taxes, you can consider withdrawing from a Traditional IRA. One consequence is that this would result in additional taxes on the amount you withdraw to pay the conversion taxes. And if you tap into the Traditional IRA when you’re younger than age 59½, your withdrawal will be subject to a 10% early withdrawal penalty. These taxes and penalties could outweigh the benefit of the conversion.
Converting at least some of the assets in your Traditional IRA into a Roth IRA may provide you with considerable flexibility in retirement. As with anything, there are pros and cons to converting your money. After weighing your options, you’ll be positioned to make the choice that’s best for your personal circumstances.
(Fig. 1) A Comparison of IRAs
Both Traditional IRAs and Roth IRAs offer unique tax advantages.
With a Traditional IRA, you have to start taking RMDs from the account each year once you reach age 72 (70½ if you reach 70½ before January 1, 2020). Since this withdrawal amount generally is treated as ordinary income, you may be obligated to pay taxes on withdrawals. With a Roth IRA, there are no RMDs for the original owner, and you can make qualified withdrawals without paying taxes.
|Taxes on withdrawals||Withdrawals of pretax contributions and earnings are taxed as ordinary income.||
Withdrawals of contributions are tax-free. Withdrawals of converted assets are tax-free but could be subject to early withdrawal penalties (described below). Generally, withdrawals of investment earnings are also income tax-free if:
|Required minimum distributions (RMDs)||You must take your first RMD by April 1 of the year after the year you turn age 72 (70½ if you reach 70½ before January 1, 2020).||None for the original owner|
|Early withdrawal penalties||Withdrawals of contributions and earnings prior to age 59½ may be subject to a 10% penalty (with some exceptions).||Withdrawals of earnings that are not qualified distributions may be subject to a 10% penalty (with some exceptions). Withdrawals of converted assets within the 5-year period may be subject to a 10% penalty (with some exceptions). A separate 5-year period applies to each conversion.|
|Spousal beneficiaries2||Subject to RMD rules||No RMDs|
|Non-spousal beneficiaries||Non-spousal beneficiaries can take distributions from an Inherited IRA before age 59½ without incurring the 10% early withdrawal penalty. They may be able to designate their own beneficiaries for the Inherited IRA. Due to the SECURE Act, going forward, the accounts of IRA owners who died after December 31, 2019, will generally need to be fully distributed to beneficiaries within 10 calendar years.|
1Subject to phaseout based on IRA owner’s modified adjusted gross income for deductibility to a Traditional IRA or for contributions to a Roth IRA.
2If spouse elects to treat the Inherited IRA as his or her own.
*A qualified distribution is tax-free if taken at least 5 years after the year of your first Roth contribution and you’ve reached age 59½, become totally disabled, died, or met the requirements for a first-time home purchase.
This material is provided for general and educational purposes only and not intended to provide legal, tax, or investment advice. This material does not provide recommendations concerning investments, investment strategies, or account types; it is not individualized to the needs of any specific investor and not intended to suggest any particular investment action is appropriate for you, nor is it intended to serve as the primary basis for investment decision-making. Any tax-related discussion contained in this material, including any attachments/links, is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this material.
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