Ready to Convert?
One of the best retirement/asset transfer plans around may also be the least understood – the Roth IRA. We love our accountants, as we suspect you do, but sometimes they get too caught up in minimizing taxes today and not thinking enough about the long term.
When many of us began saving for retirement with IRA’s, 401k’s or 403b’s way back when, the idea was simple. Save money and don’t pay tax on that money and then let it grow tax free. When we retire, we take mandatory withdrawals that are taxed as ordinary income and we pay less in taxes because we will be in a lower tax bracket.
Those last few words are important. The underlying assumption has always been that in retirement, we will be in a lower tax bracket. That may be true, but if you have accumulated any meaningful wealth, you may not be in that lower tax bracket. Between investment income, social security, and RMDs (required minimum distributions), many retirees are finding them selves in a high tax bracket anyway and the ability to manage this tax situation is limited by the mandatory RMDs and Social Security payments. Higher tax rates over the next 5 to 10 years appear likely when Congress decides it is finally time to address the U.S. budget deficits, which would just make matters worse.
One possible solution is to use a Roth IRA Conversion. The ability to make direct contributions to a Roth account is limited by income. If your modified adjusted gross income (MAGI) is more than $161,000 (single) or $240,000 (married filing joint) you can’t contribute to a Roth IRA. However, you can convert all or a portion of your IRA into a Roth IRA. There are pros and cons to this strategy and much like social security decisions, the choices can be very complex, which means these options are too often ignored.
What’s the Difference?
The key to understanding the value of a Roth IRA is to understand the differences between a traditional IRA and a Roth IRA. The traditional IRA is funded with pre-tax dollars. For example, if you earn $100K and make a $5K contribution to the IRA, your reported income would actually be $95K. You don’t pay tax on the money you contributed to the IRA. The money then grows tax-free in the IRA, but when you reach age 73, you must make minimum distributions from the IRA and these distributions are taxed as ordinary income, i.e. the maximum rate for your level of income.
The Roth IRA, on the other hand, is funded with after tax dollars. To follow the same example, if you earn $100K and make a $5K contribution to a Roth IRA, you would pay tax on the entire $100K that year. Whatever contributions are made to the IRA must be made with money that has already been taxed. Like the traditional IRA, the Roth IRA also grows tax free. The advantage is that if/when distributions are made, they are tax-free and the original owner of a Roth never has to make any required distributions.
One of the keys to making a Roth conversion work is to pay the tax with funds outside of the IRA. By using other available funds to pay the tax, the entire IRA value can be converted into the Roth. If the tax is paid from the IRA, the initial Roth value is reduced by the amount of the tax and the benefit is substantially reduced.
Here is an example to illustrate, beginning with a $200K IRA and the intention to convert half of that amount into a Roth.
By paying the tax from other assets, you are able to maintain the value of the IRA, continue to grow that account tax free, and if you meet the 5-year rule, you never pay any taxes on those funds – ever. (The Roth IRA 5-year rule says you cannot withdraw earnings tax-free until it’s been at least five years since you first contributed to a Roth IRA account.)
There is clearly a cash cost to make that Roth conversion and you are making the bet that you live long enough to make up that cost by continuing tax free growth in the account and never having to pay tax in the future. That could actually be more valuable than you think. The mounting national debt and the rapidly evolving Medicare/Social Security funding crises appears to make higher future tax rates a very high probability.
The Roth Also Benefits the Next Generation
Despite the advantages outlined above, there are cases where they are not enough to justify a Roth conversion, but there are other benefits to consider. The original owner of a Roth IRA can leave that account to his/her heirs and the heirs never have to pay tax on that money either. Like the Traditional IRA, they will have to take RMD’s and remove all of the funds within 10 years, but unlike the traditional IRA, the Roth distributions remain tax free, while the inherited traditional IRA distributions will be taxed. The RMDs and the ten-year-rule distribution make traditional IRAs among the worst possible ways to leave money to your heirs. The RMDs could easily push them into a higher tax bracket and there is little they can do about it.
However, leaving your heirs a tax-free Roth IRA is a highly advantageous method to distribute wealth to your heirs. If your retirement plan does not anticipate the need to use your IRA funds in retirement, a Roth conversion should be considered.
If any of these scenarios make sense to you we are happy to review the pros and cons of a Roth conversion as they relate to your specific situation.
Have a fabulous week!
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Palumbo Wealth Management (PWM) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where PWM and its representatives are properly licensed or exempt from licensure. For additional information, please visit our website at www.palumbowm.com.
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All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.
The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
Past performance is no guarantee of future returns.
Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that the future performance of any specific investment or investment strategy will be profitable.
401K, 403B, Estate Planning, Income Taxes, Retirement, Roth Conversion, Roth IRA, Taxes
By: Adam