All too often, people mistake general investment and tax advice for personal advice and dwell into financial risks for acting upon it. Over the years, I have read too many articles in investment and tax journals that scratch the surface on IRA tax strategies, but oversimplify the matter. In this post, we are going to discuss and provide a more comprehensive review of Roth IRA conversion and if it is the right option for you.
Comparing the Traditional IRA and Roth IRA
Below is a cross-comparison of Traditional IRA and Roth IRA.
|Taxable||Ordinary Income||Tax-Free after 5 years|
|Pro||Current Year Tax Deduction||Future Tax-Free Income (after 5 years), No Required Min. Distributions at 70 1/2|
|Con||Income taxes on distributions, RMDs at 70 1/2||No current year tax reduction, funded with after-tax dollars|
Let’s explore the two in the following scenario: an IRA owner decides to take a taxable distribution from a Traditional IRA in the current year, then convert that amount over to a Roth IRA.
The IRA owner may avoid income taxes on future distributions from a Roth IRA. This may present an opportunity for someone that is currently in a lower income tax bracket and will most likely be in a higher income tax bracket in the future. Also, money that is converted to a Roth IRA will not be subject to RMDs (Required Min. Distributions at 70 1/2 years of age).
The IRA owner must pay income taxes in current year and the conversion amount will increase current year Adjusted Gross Income, which may affect many income tax deductions, social security, and Medicare.
Lower Income Taxpayers
For an individual or household currently in the 15% tax bracket collecting social security and is going to stay in the 15% tax bracket, a Roth IRA conversion may make little sense. This may actually cause them to pay higher taxes on Social Security. However, if they are already paying the maximum on Social Security income, a Roth IRA conversion makes more sense. On the other hand, one may not be collecting social security just yet, in which case this may be a golden opportunity for tax planning.
Lower Income Taxes Now, Higher Income Taxes Later
For an individual or household currently in the 15% tax bracket or lower, but will most likely end up in the 25% bracket or higher, the Roth IRA conversions may make more sense. This should be something that is coordinated carefully with one’s cash flow demands since having enough liquidity to pay for the current income taxes will be very important. It is much more favorable that the taxes due from a conversion are paid with non-IRA assets. However, paying taxes from the IRA is also a viable option. Having an adviser(s) that understands the overall retirement income plan and tax plan is crucial to a thorough analysis.
Read more about retirement planning options and strategies.
High Income Taxes Now, Even Higher Later
One might think that Roth IRA conversions make little sense for someone already in the higher income tax brackets, but most people in the highest income tax brackets are not starving for more income in retirement. Any future distributions from IRAs will create more annual income taxes. Remember, Roth IRAs do not have Required Minimum Distributions at age 70 ½. This may help substantially lower the tax bill over a 15 to 20-year retirement. Also, if a household has a very high net worth and is facing estate tax problems, Roth conversions may help lower the value of the estate.
Beneficiaries in High Income Tax Brackets
An IRA owner that has sufficient retirement income without the need to draw down their total IRA account balance during their lifetime, but also has beneficiaries that are in higher income tax brackets may want to consider doing a Roth IRA conversion. This will allow the IRA owner to pay the lower income tax and allow their beneficiaries to inherit tax-free Roth IRAs, thus leaving more assets in the family and less for Uncle Sam.
Taxpayers that have schedule E deductions from rental losses must be careful when considering a Roth IRA conversion as it may cause the taxpayer to lose many of its benefits. Make sure to talk with a tax professional that can look at the larger picture and assess if the conversion will reduce deductions.
Funding a Roth IRA Conversion
The success of a Roth IRA Conversion will also depend on the growth of the underlying investments. Higher-growth investments will benefit the most from such strategies. However, this needs to be done in coordination with one’s investment risk tolerance. On the other hand, funding Roth IRAs with low interest baring money markets instruments or bonds may not be the best strategy either. Also, during a bear market scenario, tax payers have the ability to convert more shares or units of an investment per dollar converted. This may be a time when one may want to be a bit more aggressive with conversions.
Roth IRA conversions can be done partially and do not have to be done all in one year. One also has the ability to recharacterize a Roth conversion by the following year’s tax deadline (4/15 and 10/15 for extensions), thus undoing any planning mistakes. This is why it is so important to have a Certified Financial Planner (CFP®) and tax advisor that will take a comprehensive approach to planning. Roth IRA conversion planning is very complex and needs to be reevaluated on an annual basis with a thorough tax projection.
Bottom line is that if your current financial adviser and/or tax advisor are not proactively brining up these subjects, they are not providing valuable tax planning ideas.
Chatterton & Associates is your holistic financial planning firm for providing comprehensive wealth management services. If you are uncertain about whether or not a Roth IRA conversion is right for you, contact us today to speak with one of our certified financial advisors.
This article is not meant to be taken as personal tax advice or investment advice. It is a general description of investing and taxes. Personal tax advice and investment advice should be done with consultation from a qualified tax professional and financial advisor.