We often talk about portfolio diversification, but tax diversification of your accounts is an often overlooked source of additional spending power through the reduction of lifetime taxes paid on your income. Taxes are near historic lows in the US and could be significantly higher in the future to pay down our national debt. Additionally, there is often a window where your personal tax situation could cause a conversion to be taxed far less than it will be in the future. This is often from retirement until required distributions begin from your IRA at age 73 (75 starting in 2033). For this reason, a Roth conversion can be a useful planning tool.
A Roth IRA is also one of the best assets to leave to a beneficary since they have the chance to continue to invest it for 10 years after your death. We often see beneficieries able to double the inheritance, tax-free, during that window.
What is a Roth Conversion?
A Roth conversion (also referred to as a Roth IRA conversion) is a procedure where you transfer funds from a pre-tax retirement account, like a 401 (k) or traditional IRA, into a Roth IRA. This entails paying taxes on the converted amount in the year of the conversion. However, once the funds are in the Roth IRA, they can grow tax-free and be withdrawn tax-free after age 59.5. This plan could be especially beneficial if you anticipate your tax rate to be higher in the future. It's critical to consider your present and future financial situation, as well as the possible tax implications, before making a decision.
Anyone with a traditional IRA, no matter their income, can do a traditional IRA to Roth conversion. Moreover, people who have a SIMPLE IRA, 401(k), SEP, or 403(b) can also convert these funds to a Roth IRA, presuming they meet specific criteria.
Even if your income exceeds the limits for making contributions to a Roth IRA, you can still perform a backdoor Roth IRA. This means that you’ll owe taxes on the funds you convert, but you'll be able to take withdrawals (tax-free) from the Roth in the future.
People consider a Roth conversion because the biggest benefit lies in the tax treatment of the converted funds. Once the funds are in the Roth, future increases of those assets are tax-free.
Roth Conversion Tax Considerations and Rules
When studying the possibility of converting to a Roth, it's vital to be aware of the particular rules, or Roth IRA conversion guidelines, that manage this process. It’s important to remember that this conversion is permanent. You can't return the money to a traditional IRA. Determining whether to convert to a Roth IRA also centers on factors like:
- The tax bill you’ll need to pay to convert
- Where you will source the funds to pay the taxes
- Your future plans for your estate
- Your current tax rate versus later
When doing a conversion, you should be aware of the five year rule. If you think you may need to withdraw the money from your Roth IRA within the next five years, there may be a penalty an extra 10% penalty on the gainsIf the money was part of a Roth conversion, there's a five-year holding phase. Therefore, if you feel you'll need the funds before that time, you might want to reconsider. You could end up owing the taxes you were looking to lessen with a conversion.
All or a part of the money you convert can be deemed "reportable income" by the IRS. If you're on the edge of the next tax bracket, there's a possibility you'll get pushed up in the year you convert.
To avert this, consider converting a part of your traditional IRA. This can help you:
- Remain out of the higher tax bracket.
- Distribute the taxes related to the conversion over a few years instead of getting the entire bill in one year.
A Roth IRA Conversion: What You Should Know
Performing the conversion - If you have a considerable balance in your traditional IRA, you might want to carry out several Roth IRA conversions over a few years (“systematic Roth conversion plan”). If done correctly, a multiyear approach could let you convert a huge portion of your savings to a Roth IRA while regulating the tax effect.
For instance, you could convert just a part to keep extra money from being taxed at a greater tax bracket. Initially, in retirement, when your earned income dips but before RMDs (required minimal distributions) come into play, is a particularly excellent time to incorporate this strategy. One thing to be aware of is making Roth conversions when you are nearing the time (within 24 months) to file for Social Security and Medicare. A Roth conversion could raise your Medicare premiums and the taxes you pay on Social Security benefits.
How you'll pay the resulting tax bill. It is advisable to pay with cash from outside your IRA for a few reasons:
- Any IRA money used to pay taxes won't be accruing gains tax-free for retirement, challenging the very purpose of a Roth IRA conversion.
- If you sell appreciated assets to pay the conversion tax, capital-gains taxes can further undercut the advantages of a conversion. Moreover, if you aren’t 60 years old and withdraw money from a tax-deferred account, you'll acquire a 10% federal penalty. You may incur state penalties as well.
- Under the Tax Cuts and Jobs Act of 2017, you can no longer undo a Roth conversion. Once you convert, you can't unconvert.
The decision to convert to a Roth IRA doesn't need to be all or nothing. You might decide that distributing your savings between a traditional IRA, a Roth, a traditional 401 (k), and a Roth IRA is a feasible solution for you.
Overall, converting to a Roth IRA may deliver better flexibility in managing RMDs and possibly cutting your tax bill in retirement. It is critical to consult an advisor who is experienced with wealth management in Denver before making a move, and work with this professional every year if you decide to put into action a long-term systematic Roth conversion plan.
Reasons a Roth IRA Conversion Makes Sense
A Roth conversion can benefit those who expect to be in a higher tax bracket in the future. Furthermore, Roth IRAs provide tax-free withdrawals and growth in retirement, making them an appealing choice for those looking to reduce their future tax burden.
Roth IRAs have no RMDs.
RMDs are necessary at age 73 from traditional IRAs. Even if the money isn’t needed, it will be taxed and must be withdrawn. This could move you into a higher tax bracket. Additionally, failure to take the RMD could result in a hefty penalty. However, the penalty is reduced if the RMD is withdrawn within 24 months.
If the IRA isn’t required for retirement costs, people might think that a delay in making withdrawals is a sound strategy since it postpones any taxes that are due. However, this could also cause higher RMDs and subsequently, higher taxes due. Roth IRAs don’t have RMDs, which safeguards against these possible pitfalls.
Your Roth IRA’s Income Doesn’t Make More of Your Social Security Benefits Become Taxable
Roth IRA income doesn’t affect how much your Social Security is taxed. A part of Social Security benefits is subject to standard income tax. To decide what percentage of your Social Security benefits is taxable, you must understand how to compute your provisional income. If you’ve already begun claiming Social Security, you might already see what your provisional income (also called “combined income”) is by using charts and guidelines provided by the IRS.
If you haven’t claimed Social Security yet, you can still use the IRS’s information to gauge your future annual benefit and see your provisional income. It’s the amount of your gross income, any tax-free interest you have, and half of your projected Social Security yearly benefit. Roth IRA income isn’t a portion of the provisional income formula. By doing Roth conversions, you’re reducing the funds you have in tax-deferred accounts, helping you to avert higher Social Security taxes in the future.
Income from Your Roth IRA Doesn’t Raise Your Medicare Premiums
Another explanation for Roth conversions that may work for you is that Roth IRA income doesn't raise your Medicare premiums. This relates to something called the Medicare Income-Related Monthly Adjustment Amount (Medicare IRMAA). Required minimum distributions from traditional IRAs could make you pay extra Medicare premiums. On the contrary, Roth IRAs don’t have RMDs.
Benefits for Heirs
Roth IRAs may be given to heirs who could receive the account income tax-free. This indicates your heirs could possess the tax-free withdrawals and growth if the Roth IRA has been kept for five years or more. An important advantage, particularly useful if your beneficiaries are in a higher tax bracket.
Tax Diversification
Having both Roth and traditional accounts lets you oversee your tax liability in retirement. For instance, if your income in a particular year is greater than expected, you may withdraw from the Roth IRA without raising your taxable income.
No RMDs
401(k)s and traditional IRAs compel you to start taking RMDs at age 73. Roth IRAs have no RMD obligation in your lifetime. With a Roth account, you get more control over your retirement withdrawals, leaving the money to grow for your heirs.
We Can Help
Our wealth management team can help detect possible future tax planning strategies such as Roth conversions.
Deciding whether Roth conversions will work for you isn’t something that you should be doing on your own. Our team of professionals can help ensure that you keep and grow as much of your money as possible before, during, and after retirement. Schedule a free consultation with us today.