FEBRUARY 05, 2018
Does it ever make sense to pay taxes today when they might be deferred until later? When it comes to retirement savings, the answer could be yes.
Enter the Roth Individual Retirement Account (IRA). This type of IRA is funded with after-tax dollars, but qualified withdrawals during retirement are entirely income-tax-free.1 Roth IRAs can be especially attractive for those who expect to be in the same or an even higher tax bracket in retirement than they are now or would like greater flexibility managing income in retirement. What’s more, they aren’t subject to the required minimum distributions (RMDs) the IRS mandates you take from pre-tax or Roth 401(k)s and SEP, SIMPLE and traditional IRAs once you reach age 70½.
The hitch is you can contribute to a Roth IRA in 2018 only if your income falls below certain limits ($135,000 for single filers and $199,000 for married couples filing jointly)—but there’s a workaround. A Roth IRA conversion allows anyone, regardless of income level, to convert existing IRA funds to a Roth IRA.
Should you convert to a Roth?
You must pay income taxes on any converted funds in the year of the conversion, but there are three scenarios in which that might be a good choice.
1. You believe your tax bracket will be higher in retirement: In this scenario, paying taxes at your current tax rate is preferential to paying a higher rate in the future. Even if your tax bracket in retirement ends up being the same as it is today, you’d still pay no taxes on withdrawals—unlike traditional IRAs, whose withdrawals are fully taxable. A Roth has no effect on Social Security taxation. Other forms of income, including distributions from traditional IRAs, can increase the percentage of Social Security taxed.
2. You’re far from retirement: If you haven’t yet hit your peak earning years, the above scenario might also apply. You could be in a relatively low tax bracket today compared to your post-retirement tax bracket, particularly if you accumulate significant savings.
3. You want to maximize your estate for your heirs: If you’re fortunate enough that you don’t need to tap your IRA funds during your lifetime, converting to a Roth allows your savings to grow undiminished by RMDs, potentially leaving more for your heirs—who will also benefit from tax-free withdrawals during their lifetimes.
That said, the decision to convert to a Roth IRA doesn’t have to be all or nothing. You may find dividing your savings among Roth and traditional IRAs and a Roth or traditional 401(k), if available, is the optimal solution. As the recent Tax Cuts and Jobs Act demonstrates, tax rates are subject to change, so a variety of savings vehicles may give you the greatest room to maneuver.
How do you convert to a Roth?
If you do decide a Roth IRA conversion is right for you, you’ll need to determine two things:
1. When to execute the conversion: If you have a significant balance in your traditional IRA, you may want to carry out multiple conversions over several years. For example, if you’re currently in a lower tax bracket, you might convert just enough to stay under the next tax bracket. A multi-year approach helps spread out the resulting taxes and, if done properly, could allow you to covert a large portion of your savings to a Roth while limiting the tax impact. Early in retirement—when your earned income drops but before RMDs kick in—can be an especially good time to consider this strategy.
2. How you’ll pay the resulting tax bill: Ideally, you’d have cash on hand outside your IRA to pay the income tax on any converted funds—for several reasons:
Any IRA money used to pay taxes won’t be accumulating gains tax-free for retirement, undermining the very purpose of the conversion.
If you sell appreciated assets to pay the conversion tax, capital-gains taxes could further undermine the benefits of a conversion.
If you’re under 59½, withdrawing money tax deferred account to pay the tax could make even less sense, since you’d also incur a 10% federal penalty. (State penalties may also apply.)
Converting to a Roth IRA can give you some flexibility to cut your tax bill in retirement but be sure to consult a qualified tax advisor and financial planner before making the move.
1 In order to be a qualified distribution, the withdrawal must occur at least five years after the Roth IRA is established. At least one of the following conditions must also be met: The Roth IRA holder is at least age 59 ½ during the time of the withdrawal; the Roth IRA holder is permanently disabled; distributed assets (up to $10,000) are used toward the purchase or rebuilding of a first home for either the Roth IRA holder or a qualified family member; or withdrawals are made by the beneficiary of the Roth IRA account after the holder’s death.
What you can do next
Use our Roth IRA Conversion tool for help deciding if a conversion is right for you.
What you can do for assistance. Schedule your consultation with Mike, or call for a free consultation.
Michael D. Green,
A Registered Investment Advisor
TGA Capital Management
mgreen@tgacapitalmanagement.com
25 Braintree Hill Office Park~ Suite 200
Braintree, MA 02184
1-508-224-9646
This is not a solicitation nor recommendation to buy or sell a securities nor to imply any tax or legal advice, always seek a registered investment advisor to attain your risk/averse attitude and investment suitability before investing. All information is considered accurate and reliable, however, due to changing market, economic, taxation, institutional, and other pertinent potential cycles and variations, future results cannot be guaranteed by past performance and should be monitored on a continual periodic systematic basis to provide current advisory recommendations that meets the client short-term potential deviations and management disciplined style, while advisory provides solely long-term recommendations.