Should You Make a Roth IRA Conversion?
The $11 trillion in conventional individual retirement accounts (IRAs) amassed by Americans is a phantom.
Greg Hammer, founder of a wealth advisory company in Schererville, Ind., advises clients with money in traditional IRAs not to get too attached to their balances. He often has to remind them that either they, their spouse, or their children will owe income tax on that money.
A Roth IRA conversion, which involves transferring funds from a conventional IRA to a Roth IRA, can effectively reduce your tax liability. However, before converting to a Roth, you should consider several things.
What is a Roth IRA Conversion?
A Roth IRA is literally what its name says: it allows you to transfer your retirement funds from a traditional IRA to a Roth account. That helps you pay your tax bill in advance rather than later.
The advantages of Roth IRAs, such as tax-free rise, will apply to all of the money you convert. You won't owe any taxes in retirement, no matter how much your Roth IRA grows in value. You'll be allowed to withdraw all of the money you converted without penalty or taxes between today and then, but you have to wait at least five years since the conversion was made.
When you reach 72 years of age, you'll also be free of those annoying mandatory minimum withdrawals (RMDs). That allows your money to continue to grow for a longer period.
Hammer says that clients always wonder why they should spend $25,000 today for a conversion of a $100,000 traditional IRA. Then he asks them whether they want to pay the tax today or wait and owe RMDs on a larger balance in years to come.
Benefits of a Roth IRA Conversion
You get extra alternatives for managing your retirement tax burden when you convert retirement funds to a Roth IRA, such as:
• Get rid of RMDs. If you have cash in a conventional IRA, you have to start taking out RMDs when you reach the age of 72. It makes no difference whether you need the funds or not. The IRS requires the withdrawal to raise income tax for each dollar taken out. You can prevent this with a Roth IRA conversion, which allows you to leave every cent to your descendants if you so desire.
• Taking out money from a Roth IRA could be tax-free. You can withdraw the converted money on which you pay tax at any time and any age without having to pay income tax. However, if you’re under the age of 59 1/2 when you convert, you must wait five years to avoid a 10% penalty for early withdrawal. That is true for every conversion you do. You'll have two five-year clocks to run out if you perform a Roth conversion twice, each in a different year. There's also another five-year requirement to bear in mind: To be eligible for tax-free earnings withdrawals, you must have opened your account at least five years ago.
• Smaller required minimum distributions (RMDs) on your remaining conventional retirement accounts. You are not required to convert all of your conventional IRA funds to a Roth IRA. Partially converting to a Roth IRA is frequently the most tax-efficient option (more on this later). Whatever you convert before you reach 72 leaves less money in your traditional IRA, effectively reducing the amount of RMDs you'll have to take later.
• With less taxable income, other retirement expenses can be reduced. When you are required to take RMDs, those withdrawals are taxed. You'll have less taxable income in retirement if you mitigate your RMD burden, which may help you budget for other retirement needs. Taxable income determines your Medicare Part B premium, as well as whether and how much you owe on Social Security benefits.
• A safety net in case your retirement tax rate isn't lower. If you don't expect your yearly income from retirement funds (RMDs from conventional accounts, Social Security, and maybe a pension) to be significantly lower than your current income, you'll be less likely to pay reduced taxes later. That may make converting today, paying the tax, and growing tax-free in the future more appealing. And, though it's impossible to forecast what the tax rates will be when you retire, let alone five, ten, or twenty years later, having some tax-free retirement funds is a good idea.
• It'll be easier for your descendants. Anyone who inherits an IRA (and it’s not a spouse) must clear the account within 10 years after your death. If it's a large traditional IRA, they may face tax complications. They'll still have to take out all of the money in an inherited Roth IRA in ten years, but they won't owe taxes, and their taxable income won't be affected.
Drawbacks of a Roth Conversion
• You believe your retirement income will be significantly lower. Paying the tax on a Roth IRA conversion may not be sensible if you are currently in a high tax bracket.
• You don't have enough money to pay your tax due. You don't want to pay the tax with money from your Roth IRA conversion. It should be the goal to maintain that money growing tax-free as long as possible. If you have high-interest debt on your credit card or have to use your emergency funds, converting to a Roth IRA should not be a priority.
• You intend to relocate to a state with lower taxes. According to the head of KCA Wealth Management (Camp Hill, Pennsylvania) – Brian Kennedy, if you live in a state where conversion is taxed but planning to move to a state where it isn’t, you should wait until you move.
• You expect your family to apply for financial aid for college. The money in a retirement account has no bearing on financial aid. However, the conversion amount will appear as income on your tax return in the year you convert. That may affect the financial aid package for your family.
How Can You Convert a Traditional IRA to a Roth IRA?
A Roth conversion is the simplest when both accounts are at the same financial institution. If you don't have a Roth IRA but like the financial institution where you have your conventional IRA, you can open one and easily convert it.
Converting a conventional IRA at Brokerage 1 to a Roth IRA at Brokerage 2 involves a few steps. To begin, open a Roth IRA with Brokerage 2 Then tell Brokerage 1 that you want to do a trustee-to-trustee direct rollover to Brokerage 2 and how much money you want to transfer.
In both cases, the brokerage firm where you keep your converted Roth IRA will report the taxable distribution to the IRS via a 1099-R. In addition, you must declare the distribution on Form 8606 when you file the federal tax return for that year.
You can also get a distribution from your conventional IRA in the form of a check, which you can then deposit into your new Roth account. But that's a recipe for trouble. If you don't complete your self-managed rollover within 60 days, the full amount is considered a taxable distribution. You'd have to pay tax on it regardless of when you convert it, but if you're under 59 1/2 years old when you fail to make the 60-day deadline, you'll be hit with a 10 percent early withdrawal penalty.
How to Manage Taxes of a Roth IRA Conversion
Given all the moving elements, working with a tax professional or financial advisor who has considerable skills comprehending all the moving components is certainly worth considering.
You should probably explore a strategy that keeps your conversions to a level that won't put you in a higher tax bracket in any given year. If you retire before the age of 72 and have a lower income, those years can be a good time to convert traditional IRA funds to Roth IRA funds.
If you engage with a financial counselor, you can also talk about strategies to reduce the amount of tax you owe as a result of the conversion. One option is to harvest investment accounts losses. If you itemize your federal tax return, you might want to consider putting more charitable giving—which counts as a tax deduction—into a year when you'll have greater taxable income from a Roth IRA conversion.
When Should You Make a Roth IRA Conversion?
Converting money from a standard IRA to a Roth IRA can help you better manage your retirement tax bill and position you to leave your descendants with a more manageable financial legacy.
Because the conversion will increase your taxable income for that year, when to convert—and how much to convert in a particular year—must be carefully considered. If you're thinking about converting your Roth IRA, speaking with a tax professional or a financial advisor who has experience in Roth IRA conversions is a good idea.
