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Roth IRA Conversions

By AL MUELLER, CPA

June 8, 2021

Taxes play a significant role when we invest in retirement. One possible way to minimize taxes is by investing in a Roth IRA. With a Roth IRA, you contribute after-tax dollars and withdraw the contributions and any earnings tax-free in retirement. By contrast, you contribute before-tax dollars to a traditional IRA with the earnings growing tax-deferred, and you may get a current tax deduction for the contribution. However, you have to pay tax on all monies withdrawn in retirement from a traditional IRA. To minimize taxes on a traditional IRA, some investors are choosing to do a Roth IRA conversion.

Why Convert to a Roth IRA?

A Roth IRA conversion involves transferring retirement funds from a traditional IRA or 401(k) into a Roth account. Since the former is tax-deferred while a Roth is tax-exempt, income taxes must be paid on the converted funds at that time. However, there is no early withdrawal penalty.

A key benefit of doing a Roth IRA conversion is that it can lower your taxes in the future. Once you pay taxes on the money that goes into a Roth IRA, your earnings will grow tax-free, and distributions in retirement will be completely tax-free, provided you take a qualified distribution. By contrast, traditional IRAs force you to take required minimum distributions (RMDs) every year after reaching age 72 (age 70½ if you attained age 70½ before 2020), regardless of whether you need the money. Therefore, you lose the tax-free growth on the money you had to withdraw. With Roth IRAs, you don’t have RMDs during your lifetime. As a result, your money can stay in the account to keep growing tax-free, allowing you to manage your tax planning during retirement better.

Deciding whether to convert to a Roth IRA hinges on your tax rate now versus later, the tax bill you’ll have to pay to convert, tax diversification, and your estate plans. It is important to note that under the Tax Cuts and Jobs Act of 2017, you can no longer “recharacterize” or undo a Roth conversion. Once you convert, there’s no going back.

Why is this Important Now?

This year and perhaps next year could turn out to be the best time to convert a traditional IRA to a Roth IRA as income tax rates are likely to increase in the coming years. Lifetime income taxes could be substantially lower if you pay taxes on today’s IRA balance at today’s tax rates instead of paying higher tax rates in the future on a larger IRA balance. The potential tax increases from President Biden’s infrastructure plan are just one of the variables. For example, if you expect your household income to always be in the highest tax bracket and you will have the same or higher state income tax rate in the future, doing a Roth conversion will ensure you lock in historically low tax rates on your traditional IRA funds and reduce the risk of those funds being taxed at a higher rate in the coming years.

There are several tax planning considerations around converting to a Roth IRA, including using the tax brackets and cash in hand to pay the tax that the conversion will cause. If you plan to leave the IRA to your children, this may be an excellent time to consider converting all or part of an IRA at today’s income tax rates. If you don’t need to tap your IRA funds during your lifetime, converting from a traditional to a Roth IRA allows your savings to grow undiminished by RMD’s, potentially leaving more for your heirs, who can also benefit from tax-free withdrawals. The people who inherit your Roth IRA will have to take RMDs, but they won’t have to pay any federal income tax on their withdrawals as long as the account’s been open for at least five years.

What is Tax Diversification?

Tax diversification means having investment assets in each of the three types of accounts with different tax consequences: taxable accounts, traditional IRAs, and other tax-deferred accounts; and Roth IRAs and other tax-free accounts. None of us know what the tax law will be in the future or how it will change over time. So instead of betting on one outcome, it’s best to hedge your bets by having money in each type of account. That way, you don’t risk having the after-tax value of all your investments substantially reduced by changes to the tax code.

Tax diversification lets you practice tax bracket management in retirement because you can control which type of money you spend. For example, in a year when you’re in a low tax bracket, you can take more money from the traditional IRA. When you’re already in a high bracket or want to avoid jumping into the next tax bracket, you can take tax-free distributions from a Roth IRA or take long-term capital gains from a taxable account.

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If you have questions about the information outlined above or need assistance with another tax or retirement planning-related issue, Klatzkin can help.  For additional information, click here to contact us. We look forward to speaking with you soon.

©2021 Klatzkin & Company LLP. The above represents our best understanding and interpretation of the material covered as of this post’s date and does not constitute accounting, tax, or financial advice. Please consult your advisor concerning your specific situation.

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