• Steven J. Rosenthal, CPA, CFP, JD

Roth IRA Conversion Tax Considerations



The strategy of making regular Roth IRA conversions should be considered by persons with pre-tax retirement assets. When a Roth conversion is made from an existing IRA account with pre-tax assets, the conversions are fully taxable at the owner’s existing marginal tax rates, but the compound earnings from the Roth account are tax-free for the owner’s lifetime. Over the course of many years, the value of those conversions can far outweigh the taxes paid upfront on the conversions.


Some of the other tax considerations that make Roth conversions advantageous include the following:


  • Your future tax bracket may be higher - Given the historically low tax rates today, it is very likely that future tax rates will be higher as the federal government tries to reduce the national deficit. A retiree may also be in a higher tax bracket due to pension and Social Security payments and required minimum distributions (RMDs) that bump up taxable income. If you expect your tax rate to rise, a Roth IRA conversion allows you to take advantage of today’s low tax rates on conversions.


  • You want to take advantage of market corrections - When the stock market has moved lower as it has today, the taxable gains from Roth conversions are also lower. As the market recovers, gains inside the Roth account will be tax-free upon distribution, unlike gains from a pre-tax IRA.


  • You want to give a tax-free gift to your heirs - Traditional pre-tax IRAs are fully taxable to non-spousal beneficiaries upon an owner’s death, but the taxes may be spread out over 10 years of distribution by setting up a beneficiary IRA. However, a beneficiary Roth IRA may spread distributions over 10 years, but the income is tax-free to the beneficiaries. Roth IRA balances are not exempt from federal or Washington estate taxes, and neither are traditional IRA balances. However, the effect of making a Roth conversion is that you are effectively prepaying your beneficiaries’ future income tax bills while reducing your taxable estate simultaneously.


Roth conversions can be made anytime, but a popular window for making Roth conversions is during early retirement before RMD distributions become necessary at age 72. In fact, the conversions themselves reduce the need for taxable RMD distributions because Roth accounts have no RMD requirement. On the other hand, these conversions should be managed to avoid other negative consequences, such as the triggering of a high marginal tax rate in the year of conversion, an increase in the taxation of Social Security benefits, and an increase in premium payments for Medicare coverage. Fulcrum Wealth Advisors can help clients plan Roth conversions in a tax-efficient manner.


For more information regarding Roth IRAs, see:


https://stories.td.com/us/en/article/what-you-need-to-know-about-roth-iras

https://stories.td.com/us/en/article/what-you-need-to-know-about-roth-iras

https://www.kiplinger.com/retirement/retirement-plans/roth-iras/605202/roth-conversions-play-key-role-in-defusing-a



 

Disclosure:

Converting from a traditional IRA to a Roth IRA is a taxable event. A Roth IRA offers tax-free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first-time home purchase (up to a $ 10,000-lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.
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