31 Mar 2023 Is 2024 the Year to Consider a Roth Conversion?
Authored by: W. Dale Westenskow, CPA, Haynie & Company Partner
Is It Time For A Roth Conversion?
It looks like the wealthy are on track for a tax increase under President Joe Biden. Is it time to reconfigure retirement strategies to lessen a financial blow in the future?
One strategy that is picking up steam is converting money from a traditional IRA or 401(k) into a tax-advantaged Roth plan. However, converting to a Roth involves some considerations. Factors that can make the move a good idea or a bad one include an investor’s age, income needs, earning potential, future retirement location, method for paying the up-front tax bill that comes with a conversion, and future potential estate planning.
There may be tax changes on the horizon when you pay taxes in the upcoming year, so now may be the time to consider some changes in strategy. Arguably the toughest factor is accepting the tax consequences now under the current tax structure, rather than in the future under a different tax structure. Let’s take a closer look.
5 Year Rules
Roth IRAs are funded with money on which taxes have already been paid. The annual contribution limits are low: $6,000, plus an extra $1,000 for those over 50. These limits also phase out by the time the taxpayer’s Modified Adjusted Gross Income (MAGI) reaches $140,000 ($208,000 if married filing joint). If you hold onto the Roth account for at least 5 years, you can generally enjoy tax free withdrawals of your earnings if you are older than 59 ½ at the time of the withdrawal. If you’ve had the account less than 5 years and are under age 59 ½, you face a 10% penalty and must pay income taxes on the withdrawal of earnings.
The second 5-year rule determines whether the distribution of principal from the conversion of a traditional IRA to a Roth IRA is penalty-free. As with contributions, the 5-year rule for Roth IRA conversions uses tax years, but the conversion must occur by December 31 of the year the conversion happens.
Each conversion has its own 5-year period, but IRS rules stipulate the oldest conversions are withdrawn first. The order of withdrawals for Roth IRAs are contributions first, followed by conversions, and then earnings. If you’re under age 59 ½ and take a distribution of earnings within 5-years of the conversion, you’ll pay a 10% penalty on the earnings, unless you qualify for an exception.
So, if you do conversions each year, each conversion will have its own 5-year clock.
By contrast, a traditional IRA is funded with pre-tax funds and then (hopefully) appreciates over time. Taxpayers pay ordinary tax rates on withdrawals. While there are no income limits on who can own one, the contribution limits are the same as for a Roth. If you are participating in an employer-sponsored retirement plan, contributions to a traditional IRA create a tax deduction for those making under $76,000 (up to $125,000 for married people, depending on which spouse participates in an employer-sponsored retirement plan). If there is no participation in an employer-sponsored plan, then a full deduction is allowed.
Lock in the Tax Rates
The reason to convert traditional IRA funds to a Roth IRA is to lock in today’s potentially lower rates.
The Biden administration wants to raise the top individual rate to 39.6% from 37%, which currently hits income above $523,601 for individuals (or $628,301 for married couples).
The IRS rules do not limit how much of a traditional IRA can be converted to a Roth IRA. The converted amount hopefully appreciates over time, and withdrawals may be tax-free if certain conditions are met. The catch is that when converting, you must pay the taxes due on the conversion amount in the year of conversion.
Unlike traditional IRAs, Roth plans don’t have Required Minimum Distributions (RMDs) once an investor hits age 72. RMDs are taxable, so transferring money to a Roth can lower an investor’s annual tax bill, leaving more money for heirs.
Paying Taxes Now
So, what’s the biggest challenge for investors? Determining if the tax bite upfront is worth it. If possible, investors may want to use cash from non-retirement savings or brokerage accounts, rather than reducing what is in their retirement accounts to pay a conversion tax bill.
Complicated Decision Factors
Taxes aren’t the only issue. A conversion doesn’t make sense if an investor is going to need income from his account soon. Why? If you’re going to pay tax, either way, you’re better off having a few additional years of growth.
A conversion may also not be worth it if an aging investor plans on moving from a high-tax state to retire in a low or no-tax state. That’s because there would be no savings on the state taxes owed when transferring a traditional IRA to a Roth.
It may be best to wait until after the move and then evaluate the Roth IRA conversion. The reverse may be true if you plan to move from a low or no-tax state to a state that taxes retirement funds.
Inherited IRAs and Roth Conversions
What if you inherited a traditional IRA? Unless you’re the surviving spouse, you can’t convert it to a Roth. Things may also get complicated when converting an IRA that contains after-tax contributions.
Taxability of Social Security Benefits and Medicare Surcharges can occur as taxable income increases.
Legislation passed by Congress in December 2019 known as the SECURE Act boosted the age for starting required RMDs, to 72 from 70 ½. That means investors who are just below that age and likely retired are probably in a lower tax bracket. So, locking in that bracket by converting may make sense.
The new law also said that beneficiaries other than spouses of retirement plans of all types must cash them out entirely within 10 years of the original owner’s death. Previously, an heir may have been able to “stretch” withdrawals out over a longer period. The law makes it scary for an adult child to inherit a traditional IRA in his/her peak earning years, as the legacy would increase his/her taxable income and potentially push him/her into a higher tax bracket. This also complicates consideration for conversion.
For Help with A Roth IRA Conversion and Additional Guidance Managing Your Taxable Income, Trust Haynie & Company
As laws and limits change, it’s important to be aware of your unique tax liability—and your unique savings opportunities. The SECURE Act has made it more complex and confusing for taxpayers to understand whether a Roth conversion is a good idea. At Haynie & Company, we make it simple to stay on top of your finances. If you want to consider making a Roth conversion, please contact our office to review your specific circumstances. There are many variables where the outcome may be unknown. Reach out now to get started!
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