In this video article we discuss Roth conversions, which occur when you convert a traditional IRA to a Roth IRA. The conversion amount is taxable in the current year at ordinary income tax rates. Should you do a Roth conversion? It depends on a number of decision factors. Please consult your advisor and tax professional prior to any tax related decisions. Learn more here.
By Brandon Baiamonte, MS, CPA, CFE, CFM
Mission Wealth Director of Tax Strategy
The differences between a traditional IRA and a Roth IRA.
A traditional IRA allows you to make pre-tax contributions. You can get an immediate tax benefit, although there are income restrictions. The contributions grow tax-deferred until you take money out. Any distributions from the account are taxed at ordinary income tax rates. There may be a 10% penalty on early withdrawals, although the penalty doesn’t apply after reaching age 59 ½. You generally must take a required minimum distribution when you reach age 72. A traditional IRA may be best for those expecting to be in a lower tax bracket when taking distributions.
In summary, a traditional IRA allows you to receive a tax benefit today and also receive tax-deferred growth.
You make after-tax contributions with a Roth IRA. This means you don’t receive an immediate tax benefit, but both your contributions and earnings grow tax-free. In other words, you can take distributions without paying any income taxes. There may be a 10% penalty on early withdrawals, although the penalty doesn’t apply as long as you’ve reached age 59 ½ and have had a Roth IRA account open for at least five years. There are also no required minimum distributions during the account holder’s life. A Roth IRA may be best for those expecting to be in a higher tax bracket when taking distributions.
In summary, a Roth IRA doesn’t provide a tax benefit today, but you enjoy tax-free distributions in the future.
A Roth conversion occurs when you convert a traditional IRA to a Roth IRA. The conversion amount is taxable in the current year at ordinary income tax rates.
Should you do a Roth Conversion?
Should you do a Roth conversion? It depends on a number of decision factors, which include:
Current vs. future tax bracket.
Those who expect to be in a higher tax bracket in retirement will likely benefit from converting. Consider the timing of receiving your social security income. It sometimes make sense to convert after you retire, but before receiving social security. What will your required minimum distributions (RMD’s) be and what affect will those have on your marginal income tax bracket? A benefit of doing a Roth conversion is reducing or even eliminating RMD’s in the future. In addition, your beneficiaries won’t be subject to income taxes when they take distributions.
The longer money remains in a Roth IRA, the longer any earnings can grow tax-free. Remember that RMD’s are not required for Roth IRA’s during the account holder’s lifetime, but they are for traditional IRA’s.
Funds from other sources.
Are funds available to pay the taxes from converting? It’s better if taxes are paid from non-IRA sources. Do you need to make IRA distributions to meet your annual living expenses? If you don’t, then you may benefit from converting.
Reduction of taxable estate.
If your estate is large enough to be subject to federal and/or state estate taxes, the income taxes paid from a Roth conversion will reduce your taxable estate.
Having funds available from multiple sources (such as traditional IRA, Roth IRA, and taxable brokerage accounts) in retirement gives you flexibility in managing your marginal income tax bracket and have greater control of how much income tax liability you will have for any given year.
If you have made significant nondeductible contributions to your traditional IRA, then this will reduce the amount of income taxes paid on conversion to a Roth.
When a Roth Conversion probably doesn't make sense.
Below are several situations in which a Roth conversion probably doesn’t make sense. These include:
- You anticipate being in a lower tax bracket in the future.
- You plan to bequest (give away) IRA assets to charity.
- If you have a child applying for college and seeking financial aid.
- Increasing income from the conversion might result in additional taxes or reduced deductions and credits. Examples of this include the net investment income tax, the child tax credit, medical expenses, and medicare part B and D premiums.
- Roth conversions can no longer be recharacterized per the 2018 Tax Cuts and Jobs Act. Conversions are therefore irrevocable, and so don’t convert unless you are sure.
As you can see, there are numerous factors that will help you determine whether a Roth conversion makes sense.
Please discuss this with your financial advisor and CPA, as every situation is unique.
How Mission Wealth Can Help
At Mission Wealth we help you explore the most cost-effective solutions to help cover a number of possibilities. We are a fiduciary for our clients, and have no proprietary products to sell and no quotas to fill. We simply offer independent, objective advice that serves your best interests.
We offer experience and resources that can help create a total coordinated picture. Our advisors can provide objective advice that aligns your financial position with your biggest dreams and aspirations.
Our Tax Management Services Include:
- Estate Tax Reduction Strategies
- Annual Tax Management Review (for Integrated Wealth and Private Clients)
- Concentrated Stock Planning (Access to LPs)
- Integration & Coordination with CPA on Tax Savings Strategies
You can find more information by visiting missionwealth.com/tax-management.
Your client advisor at Mission Wealth is available to help coordinate with your tax advisor and is a great resource to help plan for and implement this and other strategies. If you don't have an advisor but would like to learn more, you can contact us by phone or via our website and an advisor will be in touch. Please visit www.missionwealth.com to learn more.
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