There has been a lot of buzz around our office lately about Roth IRA conversions. It is a hot topic of conversation in the low income tax environment we are currently experiencing. This blog post will attempt to explain what a Roth conversion is and to give you some insight as to whether or not it is right for you.
If you’re new to retirement savings, IRAs are saving vehicles that allow you to tax efficiently save for your future. A traditional IRA (IRA for the purposes of this article) allows you to set aside money before it is taxed. This money then grows tax-deferred (no tax in the years it is growing) and is then taxed as ordinary income when the money is distributed later in your retirement years. It can be a very powerful & ubiquitous tool for retirement savings.
An IRA does come with a couple of drawbacks. First, all IRA owners are required to begin taking a minimum amount of distributions at age 70 ½ called, appropriately, Required Minimum Distributions (RMD). This annual distribution is based on actuarial life expectancy and can result in withdrawing more money than a retiree needs, thus triggering unnecessary taxes. Second, although the taxes on the growth are deferred until retirement, the entire amount (contributions and growth) will be taxed at your ordinary income tax rate when the money is taken out. This can be a negative as the growth of an investment in a non-IRA account, although taxed when the profit is recognized, is taxed at the more efficient long-term capital gains rates. This means you are likely to pay more tax ultimately on the growth portion of the IRA.
These negatives are certainly not enough to outweigh all of the positives an IRA has to offer, but they should be considered carefully when making financial decisions.
A Roth IRA, on the other hand, is taxed the opposite way. In a Roth IRA, the funds are contributed after-tax and will then grow and be distributed 100% tax -free. Essentially, when you put your money into a Roth, you will never owe a dime of tax again (as long as it is allowed to grow at least 5 years). In addition, there are no RMDs enabling a retiree to take their tax-free money when they need it, not when the government requires them to do so.
Most financial planners love Roth IRAs for their clients for all the reasons mentioned above. Unfortunately, not everyone qualifies for a Roth IRA as there are income limits and the annual contribution amount (even if you are eligible) is far less than that for a 401k or other employer sponsored qualified plan. A Roth can be powerful, but also can be difficult to get money into.
Enter the Roth conversion. A Roth conversion gives an investor the ability to convert some or all of a traditional IRA to a Roth IRA. There is currently no annual limit on how much can be converted unlike Roth contribution limits. Any amount that is converted is recognized as income in the year of the conversion and added on top of an investor’s current income for the year. Unfortunately, we have a tiered tax system in the United States and as such, your income tax rate increases when earnings are higher. This system has made it prohibitively expensive for most to convert their IRA in previous years. That, however, was before the tax cuts of late 2016.
We are now in a period of very low taxes. In fact, a married couple can earn $321,450 and remain in the 24% Federal income tax bracket. This opens the door for many who have been either unable or unwilling to make Roth contributions, to convert some or all of their IRAs to a Roth at a very low tax rate.
Those who choose to do a Roth IRA conversion will not only lock in 2019 tax rates on the amount they convert, but they will never pay taxes on the Roth assets again; not even on the growth of the investments. A conversion of $100,000 for a 45-year-old woman in 2019 can mean more than $400,000 of tax-free money if properly invested when this woman is in her 60s and 70s. That’s powerful.
How can you determine if a Roth conversion is right for you? Unfortunately, this is a bit more complex than it sounds. Even for those already in retirement, a Roth conversion looks like a favorable long-term tax strategy. However, there is far more to consider than just income tax rates. Your adjusted gross income impacts other things such as the tax on Social Security benefits, Medicare premiums, and even capital gains taxes. All of these components should be considered when making the decision to convert or not. If none of these apply to you, then it just becomes a simple calculation of how much you are comfortable converting today and pre-paying the tax on. $1,000? $5,000, $50,000, $200,000? There is no one right answer for everyone. And since it seems as if low tax rates will be here for at least a couple more years (and perhaps longer depending on the 2020 election), then there is time to do your conversion in annual chunks to spread out and reduce the tax burden.
If you are not sure if a Roth IRA conversion is right for you, consider reaching out to a fee-only financial planner, such as Zynergy Retirement Planning, for some expert advice. Your future self will be very happy that you did.