And just like that, 2020 is (finally) coming to a close. As you get your financial house in-order and work through year-end planning, you may want to consider a Roth IRA conversion.
Tax Planning is Key
The primary consideration in a Roth conversion relates to your current and future tax situation. In a conventional Roth conversion, you are able to convert some portion of your Traditional IRA (or other qualified retirement plan like a 401(k)) into a Roth IRA. Assuming that the contributions to the Traditional IRA were never taxed, then the amount converted to the Roth IRA will be taxed at your ordinary income tax rate. This conversion-related tax will be due by the April 15th filing date.
If you are thinking about a Roth conversion, consider your taxes today compared to your potential taxes in the future. Is it more advantageous to pay taxes on the conversion today in exchange for tax-free growth and distributions in the future, or to simply let the assets continue to grow tax-deferred in the Traditional IRA? We don’t have a crystal ball and cannot predict how future tax rates might look. However, as a general rule, the higher your income, the more taxes you will pay (thanks Uncle Sam!). If you believe that your income and related taxes will increase in the future, then a Roth conversion might be the right decision. If you think your income and related taxes will decrease in the future, then you will likely want to let the Traditional IRA assets continue to grow.
Also consider your retirement account mix. If most of your assets are in a Traditional IRA, a Roth conversion will provide tax diversification and additional flexibility when the time comes to withdraw.
Backdoor Roth Conversions
Another avenue for converting Traditional IRA assets to a Roth is through a “Backdoor” conversion. This is a useful tool if both of the following apply to your situation:
- You are still working and earning income.
- Your income exceeds the Roth IRA contribution threshold.
Assuming #1-2 above apply, you can elect to make a non-deductible Traditional IRA contribution. Also note that if you are a high earner and you are covered by an employer-sponsored qualified plan (like a 401(k)), contributions to a Traditional IRA are not deductible. The non-deductible Traditional IRA contribution is key to the mechanics of a Backdoor Roth conversion, which occurs in two steps.
The first step is to make a non-deductible contribution to your Traditional IRA. The second step is to convert the Traditional IRA contribution into a Roth IRA. Note that any earnings that accrue to the non-deductible Traditional IRA contribution will be taxable upon conversion. To avoid any tax liability when converting, consider contributing to a low-yield money market fund. To maximize tax efficiency, you can execute the conversion the day after you make the Traditional IRA contribution. This limits the amount of time that the contribution can grow and reduces the risk that you will owe taxes when you convert.
One final consideration is related to the “pro-rata rule.” The IRS does not allow taxpayers to elect only non-deductible Traditional IRA contributions for conversion if you also have existing deductible IRA funds. Instead, a pro-rata calculation is performed to figure the tax liability. This may erode any conversion benefit. Talk to your CPA about any impacts the pro rata rule may have on your conversion.
Potential Pitfalls and Additional Considerations
While tax implications are paramount, also keep the following topics in mind as you consider a Roth conversion:
- Conversions are permanent (no Mulligans!).
- Understand the “pro-rata” rule tax implications.
- Ensure cash is available to pay conversion-related taxes. Paying conversion-related taxes with dollars retained from the conversion reduces the benefit of compounding as the assets grow. And, if you are not yet 59 ½, any dollars retained to pay the tax bill could be subject to a 10% penalty!
- Keep an eye on Medicare and Social Security benefit income thresholds. Converted amounts might increase your income to levels that put you at risk for additional Medicare costs and/or Social Security income tax.
- A longer investment time horizon creates more potential for tax-free growth and lends itself to a Roth conversion.
- The CARES Act waived required minimum distributions (“RMDs”) from qualified retirement plans (i.e. Traditional IRA, 401(k)) in 2020. This may create an opportunity to take a discretionary distribution in 2020 and convert to a Roth IRA.
Final Thoughts
Speak with your financial and tax advisor(s) to see if a Roth conversion is right for you. A conversion could mean future tax savings and enhanced flexibility during retirement.
Securities offered through Raymond James Financial Services, Inc., member FINRA/SIPC. Investment advisory services offered through Raymond James Financial Services Advisors, Inc. Stonegate Financial is not a registered broker/dealer and is independent of Raymond James Financial Services. Any opinions expressed are those of Trey Stilley and not necessarily those of Raymond James. Please note, changes in tax laws or regulations may occur at any time and could substantially impact your situation. While familiar with the tax provisions of the issues presented herein, Raymond James financial advisors are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional. Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.