The end of 2021 is nearing, and you are contemplating tax strategies and planning how to minimize income tax liability for either this current tax year and/or future tax years.
You may have heard from financial institutions, friends and/or family encouraging you to convert a Traditional IRA into a Roth IRA.
Well, should you? The answer to this question will vary as each person’s tax situation is different. Below is some information for you to consider in your decision making process.
We can perform financial modeling to estimate the financial advantages or disadvantages from a Roth Conversion.
Some Basic Requirements for a Roth IRA Conversion
- 31 December is the deadline for the distribution from the Traditional IRA to be completed so it can be converted into a Roth. Don’t be confused with the normal 15 April deadline for IRA contributions. Conversions must be completed within 60 days after the end of the tax year.
- All or part of the distribution from your Traditional IRA may be taxable income. At the moment there are basically no limits on the size of Roth conversions.1
- There is no limit to the amount that can be converted but tax on the conversion is fully due for the tax year of conversion.
- There is a five-year waiting period for qualified distributions. Distributions taken after the 5-year period beginning with the year the contributions were made to the Roth IRA and taken after you reach age 59 ½ are considered qualified distributions, not subject to income tax or early withdrawal penalties.
- With the passing of the Tax Cuts and Jobs Act, beginning January 1, 2018, conversions from a traditional IRA, SEP or SIMPLE to a Roth IRA can no longer be recharacterized. Meaning, Roth Conversions cannot be undone.
Disadvantages of A Roth Conversion and Reasons Not To Convert
- The 5-year rule. Don’t perform a Roth Conversion if you think you may need the money during the next 5 years. To avoid taxes and penalties, you must wait 5 years before withdrawing from the conversion. Example: If you made a Roth Conversion on March 17, 2021, this is treated as if it was made on January 1, 2021, and you’ll need to wait until January 1, 2026, before you can take a qualified distribution. There are some exceptions, i.e. making a down payment on your first house, higher education expenses, medical expenses/health insurance premiums or if you lose your job.
- A Roth Conversion increases your taxable income and If you’re currently collecting Social Security benefits this could cause more of these benefits to be taxed. Up to 85% of your Social Security benefits can be taxed. This could also cause your Medicare costs to rise if you’re receiving Medicare benefits.
- Qualified Charitable Distributions (QCDs). If you plan to use large distributions from your IRA donate to charities, i.e. QCDs, then Roth Conversions would be counterproductive. QCDs are an effective means of reducing the tax liability of your RMDs (Required Minimum Distributions).
- If you plan on leaving the IRAs as an inheritance, it might be better to let the beneficiaries pay the tax, especially if they are likely to be in a lower tax bracket.
- Taxes are due for the year of conversion and the conversion may push you into a higher tax bracket. Example: If you want to convert $50,000 from a Traditional IRA into a Roth IRA, your taxable income has increased by $50,000.
- If your taxable income (not to be confused with adjusted gross income) is $75,000 before the conversion and your filing status is Married Filing Joint, for 2021 you are in the 12% tax bracket with room for another $8,550 before you enter the 22% tax bracket.
- In this scenario, of your $50,000 conversion, $8,550 gets taxed at 12% and the remaining $41,450 gets taxed at 22% for a total of $10,145 in taxes that are due by April 15 (tax deadline) next year when your tax returns are filed.
- If you have children in college, the amount being converted to a Roth is treated as income and could affect the parents’ Expected Financial Contribution (EFC) that is calculated as part of the Free Application for Federal Student Aid (FAFSA), possibly reducing financial aid available to the student(s).
Advantages of A Roth Conversion and Reasons to Consider a Conversion
- Roth IRAs do not have RMDs (Required Minimum Distributions) during the lifetime of the original owner, so you can leave the money in the account as long as you like and are not forced to take withdrawals at age 72 as you are with Traditional IRAs.
- Qualified Distributions from Roth IRAs are tax-free, earnings included.
- Roth IRA Distributions do not affect the taxability of your Social Security Benefits. Distributions for Traditional IRAs are taxable income and can increase the taxability of your Social Security Benefits.
- Potential to leave more of your estate tax-free to heirs. Roth IRAs allow for savings to grow tax-free without being reduced by RMDs. So, instead of having to take money out at age 72, savings and earnings can continue to grow for years after RMD age. Beneficiaries can benefit from the same tax-advantaged treatment of withdrawals without paying taxes or penalties if the 5-year rule is met, and other IRA inheritance rules of distributions are met. These rules can vary based on the beneficiaries’ relationship to the original account owner.
- If one spouse is expected to significantly outlive the other, the new filing status of single for the surviving spouse results in higher tax brackets and a lower standard deduction. Tax-free withdrawals from a Roth IRA could provide tax-free income for the surviving spouse.
- If you plan on retiring in another state that has higher tax rates, Roth distributions would avoid the higher rate. But if you relocate to another state that has no income tax, then a Roth conversion would not save you any taxes in the new state and you’ll have paid state taxes in your current state of residence when you performed the conversion.
