Roth IRA conversions: Paying taxes sooner than later may make sense
Once banned for those with incomes over $100,000, Roth IRA conversions today are open to all and particularly popular among people of high net worth as a powerful retirement and estate planning tool. For those willing to pay taxes up front, conversions can shelter wealth from higher future tax rates, create flexibility in retirement assets and remove a tax onus from heirs.
Even if the 2017 tax cuts are extended past their tentative expiration date of December 31, 2025, the strategy can be beneficial and is worth investigating to see if it is right for you.
“A Roth conversion can potentially provide financial benefits that last for years and even across generations,” noted Altair’s director of financial planning, Caitlin Dixon. “For clients where this option makes sense, we are encouraging them to make that change now.”
That said, we recommend talking to your Altair service team about a possible conversion. They can share perspective on your situation and help to manage the process which is particularly important given the rules that could trigger penalties if not followed carefully.
How it works
A Roth IRA conversion is a penalty-free taxable transfer of assets from other retirement plans such as traditional IRAs and 401(k)s into your Roth. The funds converted are subject to federal income tax in the year of conversion. Penalty taxes may apply if using IRA money to pay the taxes. Strict income and other requirements were lifted in 2010, making it an option open to everyone.
Benefits
A conversion can:
- Diversify your tax exposure by enabling more of your assets to be free of taxes when withdrawn.
- Allow you to pay taxes at a lower rate – if tax rates rise and you expect your own tax obligations to increase in the future.
- Lessen your future RMDs. Assets in Roth IRAs are not subject to required minimum distributions since you have already paid taxes on them.
- Maximize wealth transfer. A conversion allows your savings to grow undiminished by RMDs, potentially leaving more for your heirs. And it can save them from big tax bills by allowing them to generally withdraw the money tax-free as long as they follow IRA rules for minimum distributions. And for those who will be subject to estate tax at death, paying the income tax on the Roth conversion means the money used to pay that tax won’t be subject to estate tax at death, providing an overall more tax efficient means of paying tax on the IRA.
Downsides
The negatives mean it may not be appropriate for everyone:
- Substantial conversion taxes. If you cannot pay the taxes using other sources, converting to a Roth may not make sense. Paying the taxes from the IRA would mean you will lose the potential advantage of tax-free growth on the amount paid in taxes. And those under 59½ will likely incur a penalty for doing so.
- Depends on time horizon. Money that you will need soon is not a good candidate for conversion because your assets may not have time to recoup the taxes you would have to pay. In addition, withdrawing converted funds within five years of the conversion will trigger a 10% penalty.
- Social Security and Medicare costs. If a Roth conversion increases your taxable income, more of your Social Security benefits would be taxed and your Medicare premiums could rise temporarily.
- Certain charity considerations. If you plan on giving a significant amount of your traditional IRA to charity using a QCD (qualified charitable distribution) in order to satisfy your RMDs without creating taxable income, or to a charitable beneficiary at death, a conversion to a Roth could be counterproductive.
How it’s done
You’ll need to open a Roth IRA account at a financial institution if you don’t have one already.
Once you have a Roth, there are three basic ways to convert assets from another retirement savings plan to it: a rollover, a trustee-to-trustee transfer, and a same-trustee transfer if the same financial institution holds both accounts. The tax ramifications and required forms and timing may make it advisable to seek help from your financial adviser, however. You can end up exposing assets to a higher tax bracket and you could incur penalties for not adhering to the required timing or not filing the appropriate forms.
Best time to do it
If you and your financial adviser conclude that a Roth conversion makes sense, it is generally best to convert sooner than later to allow more years of tax-free growth in the Roth IRA.
You may wish to carry out a systematic Roth conversion plan over multiple years, converting just enough of your savings each time to keep your income from rising to the next higher tax bracket. The early years of retirement, when your earned income declines but before RMDs kick in, can be a particularly tax-savvy time to implement this strategy.
In summary
Roth IRAs offer a unique and exciting retirement savings opportunity. Converting to a Roth can provide you with greater flexibility in managing RMDs and be advantageous for your future tax obligations and your heirs. However, working with a qualified tax adviser as well as your Altair team on the move is strongly recommended.
The material shown is for informational purposes only and should not be construed as accounting, legal, or tax advice. Although we made efforts to verify the accuracy of the information, Altair Advisers cannot guarantee its accuracy. Please see Altair Advisers’ Form ADV Part 2A and Form CRS at https://altairadvisers.com/disclosures/ for additional information about Altair Advisers’ business practices and conflicts identified.