Converting a traditional IRA to a Roth IRA
The proposal by President Biden to increase the top marginal income tax rate from 37% to 39.6% has tax planners scrambling for ideas to minimize the impact on individuals. The top rate is scheduled to be raised to 39.5% after 2025, when current tax cuts are set to expire. If Congress does pass the legislation, it will kick in for the 2022 tax year. With the thought of higher tax rates in the future, converting a traditional IRA to a Roth IRA may be a good planning step.
The basic idea behind a conversion to a Roth is to pay off some or all of your tax deferred pre-tax-retirement account now, in favor of having all the advantages of an after-tax Roth IRA account over the long run. If you anticipate your tax rate increasing in the future, conversion now should be looked at.
Tax rates may not be the only factor to consider when evaluating whether or not a conversion is right for you. There are other benefits to consider. The SECURE ACT passed in 2019 ends the estate planning strategy of a stretch IRA. By using the stretch strategy, an IRA could be passed on from generation to generation, taking advantage of tax-deferred and/or tax-free growth of the assets within it. Today beneficiaries of traditional IRAs or other pre-tax retirement accounts will have an accelerated Required Minimum Distribution (RMD) schedule according to the 10-year rule. This means that if you have a large amount in pre-taxed dollars your beneficiaries will have to incur a larger income tax burden for the 10 years following your death. This will force your beneficiaries to distribute the full amount inherited within 10 years while including amounts distributed in their taxable income, which may come at a time they did not want to realize that additional income.
If you are planning to convert your IRA to a Roth, make sure you have some non-IRA money to pay the taxes owed. Simply, you want to maintain all the money you can in your Roth because future earnings will not be taxed. Also remember if you are under the age of 59 ½ and convert your IRA to a ROTH you will have a 10% penalty applied to distributions used for paying taxes.
If you are eligible and do not already have a Roth IRA, it would be beneficial to start one. This would start the clock on Roth IRA’s five-year rule. The five-year rule is used to determine if the earnings, or interest, from your Roth IRA will be tax- and penalty-free. For your earnings to be a qualified tax-free distribution you must be over age 59 1/2 and have at least five years after the first contribution to your Roth IRA. Roth conversions have a special five-year rule, in that each conversion has its own five-year period. The IRS uses the FIFO rule, so first dollars in are the first dollars out. If you make multiple conversions over numerous years each would have its own five-year clock, with earnings from the first conversion coming out first.
Roth conversion may have many benefits for you and your beneficiaries. With increases to income tax brackets on the horizon now is the prime time to review your personal circumstances to see if a Roth conversion is right for you. This is a complex piece of financial planning that is heavily factored based on your taxation level, your overall financial position, your health and your desire to leave a legacy to your love ones.
Most financial and tax professional have computer programs that can project the tax consequences of a Roth conversion. Before making any major decision consult the professionals.
Bob Hollick is a State Farm Insurance agent based in Washington. His column appears every other Friday in the Observer-Reporter.