A Roth IRA is a great way to save for your retirement and can be a vital strategy to help manage taxes down the road. You can transfer tax-deferred Traditional IRA funds to a Roth IRA through a conversion, and Roth IRAs can also provide tax free income.
There are some important things to know before making a Roth conversion - it’s like the old saying, the devil is in the details. Let’s jump tight in!
A Roth conversion essentially means you are converting funds from a Traditional IRA to a Roth IRA.
The Big Surprise you need to know about Roth conversions is you will pay taxes on the amount of the conversion up front! You should have the funds available to pay the tax on the conversion.
Big conversion, big tax. Little conversion, little tax.
Why Convert?
The bottom line is to save on future taxes. What does your crystal ball say about future income tax rates? Roth conversions can help you hedge against future tax hikes. The idea is to pay today's tax rate to avoid paying a higher tax rate on your distributions later.
It’s widely known that Congress may soon raise taxes. While there is a long way to go, some proposals have had the top tax rate increasing to 39.6% from 37% for singles with annual incomes of more than $400,000 and couples earning more than $450,000.
Even if Congress doesn’t raise taxes soon, current tax rates will sunset in 2026, reverting to 2017 levels. You might think of income tax rates as being on sale right now - yeah weird!
Can Help With Other Taxes
Qualified Roth IRA withdrawals are tax free and do not count towards modified adjusted gross income (MAGI). This can help prevent you from triggering the Medicare surtax on net investment income - a threshold to be aware of.
Also, there are no required minimum distributions on Roth IRAs that you have to deal with like there are with Traditional IRAs when you reach age 72 or over.
Kids in a higher Tax Bracket?
Beneficiaries can inherit a Roth IRA without taxes as well. Even though they would need to take a required minimum withdrawal each year from an inherited Roth IRA, the minimum withdrawal would be tax free as long as all rules were met by you - the original owner. This could really help your beneficiaries, especially if they are in a higher tax bracket - there could be several good possible scenarios here.
How Do I Get Qualified Tax-Free Distributions?
Getting tax free income from a Roth IRA mostly depends on two things - your age and the inception date of your Roth IRA:
You must be age 59 ½ or over, to withdraw tax free income (aka qualified distributions) and
Your Roth IRA must have been open for at least 5 years.
Also, before you can withdraw money from converted funds without a penalty, there is a 5 year holding period that each conversion must meet. But, you generally don’t have to worry about holding periods if you are over age 59 ½ and your Roth has been open 5 years or more.
5 Star Tip: Guess what you should have opened by now?!
Contributions vs Conversion.
IRA contributions (whether Roth or Traditional IRAs) are generally due by April 15th, but conversions should be done by the end of a calendar year.
In other words, you do not have until April 15th to make a Roth Conversion for calendar year 2021. Conversions are due by December 31 to count for the year. Time’s almost up!
You might have enough time to pull this off if you have both your Traditional IRA and Roth IRA already opened and at the same custodian.
The Wrap
Roth IRAs can provide tax free income in retirement if you meet the requirements. It can help reduce taxes in other areas as well, and also to your beneficiaries, and help eliminate the need for RMDs.
You can accelerate the balance of your Roth IRA through more or larger conversions, but be super-careful! Since taxes are involved, I strongly advise you to get help before converting. It just so happens I have a lot of experience at this, so let me know if I can help. I’m a fiduciary, no commission wealth advisor who would enjoy hearing from you.
Cheers!
John Piershale, CFP®, AEP®
John Piershale Wealth Management, LLC is an Investment Adviser registered with the State of IL and in other jurisdictions where exempt from registration. All views, expressions, and opinions included in this communication are subject to change. This communication is not intended as an offer or solicitation to buy, hold or sell any financial instrument or investment advisory services. Any information provided has been obtained from sources considered reliable, but we do not guarantee the accuracy or the completeness of any description of securities, markets or developments mentioned.
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