Converting a traditional IRA to a Roth IRA can be a smart option for individuals seeking tax-free growth and the flexibility to take tax-free withdrawals in retirement or pass their savings to future generations free of federal income tax. However, employing this strategy contains significant financial implications that individuals must address and carefully plan for before the conversion.
It is first important to understand that there are four critical differences between traditional IRAs and Roth IRAs:
A Roth conversion involves withdrawing contributions and earnings from your tax-deferred traditional IRA, paying taxes on that amount upfront and depositing them into a Roth account. While the transferred funds can yield tax-free savings going forward, you should consider the significance of your immediate tax liability and whether the timing and rationale for the conversion make sense for your unique circumstances. More specifically, ask yourself the following questions.
Do I have the resources to pay the conversion tax today?
You may choose to hold back some of your traditional IRA funds to cover all or a portion of the conversion tax. However, the amount you withhold may be treated as an early distribution subject to tax and penalties depending on your age and the timing of the conversion. Alternatively, you may sell non-retirement assets and use those proceeds to pay the conversion tax, but that, too, can have costly consequences in the form of capital gains taxes.
The better option is to pay the conversion tax with cash on hand, ensuring you have ample funds to cover your living expenses, especially during the 5-year holding period when withdrawals from the Roth IRA could trigger tax liabilities.
How will a Roth IRA conversion affect my current and future tax liabilities?
A Roth IRA conversion enables you to pay tax at today’s low rates rather than bearing that financial burden in later years when your income and tax rates may increase. Therefore, a conversion makes sense if you expect to be in a higher tax bracket in retirement, especially when Social Security benefits and RMDs from traditional IRAs and 401(k)s will increase your taxable income. However, if you do not need or plan to tap into your retirement savings during your lifetime, a conversion to a Roth plan unfettered by RMDs can allow you to pass more of your wealth to beneficiaries outside your taxable estate. While beneficiaries will be required to take RMDs from inherited Roth IRAs, they can avoid income tax on those withdrawals. It is important to work with financial advisors to run the numbers and help determine the best timing of a conversion based on your unique circumstances.
Is now the best time for a Roth IRA conversion?
Essentially, a Roth IRA conversion should occur when your tax bracket and taxable income are lower than what you expect they will be when you need to begin taking withdrawals in retirement. While it may be difficult to predict how ordinary income tax rates will change in the future, you can look at your age and annual earnings as a starting point for this assessment.
For example, it may be prudent to execute a Roth IRA conversion in the early years of your retirement, when you are no longer drawing a paycheck and not old enough to claim Social Security or be subject to RMDs in pre-tax accounts. By contrast, converting an after-tax account to a Roth at the height of your career earning potential or in a year of a significant liquidity event may bump you into a higher tax bracket, which could lead to a higher tax on the conversion. However, a partial conversion of long-term growth assets battered by the market may make sense, even at the prime of your earning year, when those investments pay high dividends, or they are expected to recover over the longer term.
Timing a Roth IRA conversion should also consider the five-year rule, which requires you to own the Roth account for five years before taking withdrawals. Distributions taken before the holding period is over and/or before you reach age 59½ will be subject to income taxes and early withdrawal penalties.
Roth IRA conversion can be a tax-efficient strategy for many retirement savers when you seek the counsel of your tax and financial advisors to help ensure that it meets your short-term needs and longer-term estate plan goals.
About the Author: Robert Mark Weiss, CFA, is a regional director and financial planner with Provenance Wealth Advisors, an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs, and a registered representative with PWA Securities, LLC. For more information, call (941) 308-1126 or email info@provweath.com.
Provenance Wealth Advisors (PWA), 200 E. Las Olas Blvd., Nineteenth Floor Ft. Lauderdale, FL 33301Â (954) 712-8888.
Robert Mark Weiss is a registered representative of and offers securities through PWA Securities, LLC, Member FINRA/SIPC.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct.
Any opinions are those of the advisors of PWA and not necessarily those of PWA Securities, LLC. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of PWAS, we are not qualified to render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional. Prior to making any investment decision, please consult with your financial advisor about your individual situation.
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. Changes in tax laws may occur at any time and could have a substantial impact on each person’s situation. While we are familiar with the tax provisions presented herein, as financial advisors of PWA Securities, LLC, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.
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Posted on November 12, 2024