Cash Issues: Roth Conversions

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Money Matters: Roth Conversions

Advised by Marc Hebert, President of The Harbor Group Inc., a certified financial planner. If you have any questions about finance or would like to suggest a future topic, send an email to webstaff@wmur.com. There is still time this year to consider a financial move – converting your traditional IRA to a Roth IRA. This refers to the process of taking funds in your traditional IRA, paying tax on it, and transferring the funds to a Roth IRA. You can choose to convert all of your traditional IRA account or just part of it. What is a Roth IRA? A Roth IRA gives you the option of tax-free income during your retirement years. This is partly due to the fact that Roth IRA contributions are not tax deductible. The income on the Roth account grows tax-free. Qualified withdrawals are also income tax exempt. This may also apply to state income taxes, but it’s best to check your state tax law for confirmation. To be eligible for qualifying distributions, a Roth IRA account must typically have been opened for five years. In addition, the owner must be at least 59 ½ years old, permanently disabled or receive the account as a death. These are the general rules – there may be other exceptions that apply to your situation. The ability to convert funds in a traditional IRA to a Roth IRA does not depend on your income or tax return status. There is no limit to the amount you can convert. You can also convert funds several times a year. The restriction on this applies to inherited accounts. For beneficiaries other than spouses, an inherited traditional IRA cannot be converted to a Roth IRA. On the other hand, a recipient spouse may treat the inherited traditional IRA as their own. In this case, the spouse can convert the account to a Roth. Since traditional IRA contributions are usually tax deductible, converting the funds to a Roth means paying federal income taxes on the converted amount. These are paid in the year of conversion. Check your state tax situation again. A Roth conversion could lead to a higher tax bracket and more taxes for the respective year. You need to weigh those taxes against the potential never to pay income taxes on the funds again. Unlike the traditional IRA, Roth IRAs are not subject to required minimum distributions. You will not be forced to take money from your Roth while you are alive. So why consider a Roth IRA now? In today’s environment of relatively lower tax rates, this might make sense. Assuming tax laws don’t change, the lower tax rates will expire in late 2025. Increasing deficits due to the pandemic can later lead to higher tax rates. Taxes are the big unknown. Switching to a Roth IRA can make sense if you think you are in a higher tax bracket when withdrawing funds. Traditional IRAs may make more sense if you think your tax bracket is lower when using the funds. If your traditional IRA investments have depreciated, the conversion may cost you less tax. You may have had financial challenges this year that could result in lower income. Lower incomes and thus lower tax rates can mean that there is more room for conversion before switching to the next tax bracket. It is important to consider how you will pay the taxes generated by the conversion. The Roth conversion strategy works best when you have other means of paying the tax due and not using any part of the traditional IRA distribution to cover it. The end of the year is getting closer. This is a strategy to consider that could benefit your financial picture in the future. It may be advisable to discuss your options with a certified financial planner who is familiar with your individual situation.

Advised by Marc Hebert, President of The Harbor Group Inc., a certified financial planner. If you have any questions about finance or would like to suggest a future topic, send an email to webstaff@wmur.com.

There is still time this year to consider a financial move – converting your traditional IRA into a Roth IRA. This refers to the process of taking funds in your traditional IRA, paying tax on it, and transferring the funds to a Roth IRA. You can choose to convert all of your traditional IRA account or just part of it.

What is a Roth IRA? A Roth IRA gives you the option of tax-free income during your retirement years. This is partly due to the fact that Roth IRA contributions are not tax deductible. The income on the Roth account grows tax-free. Qualified withdrawals are also income tax exempt. This may also apply to state income taxes, but it’s best to check your state tax law for confirmation.

Typically, a Roth IRA account must have been opened for five years to be eligible for qualifying distributions. In addition, the owner must be at least 59 ½ years old, permanently disabled or receive the account as a death. These are the general rules – there may be other exceptions that apply to your situation.

The ability to convert funds in a traditional IRA to a Roth IRA does not depend on your income or tax return status. There is no limit to the amount you can convert. You can also convert funds several times a year. The restriction on this applies to inherited accounts. For beneficiaries other than spouses, an inherited traditional IRA cannot be converted to a Roth IRA. On the other hand, a recipient spouse may treat the inherited traditional IRA as their own. In this case, the spouse can convert the account to a Roth.

Since traditional IRA contributions are usually tax deductible, converting the funds to a Roth means paying federal income taxes on the converted amount. These are paid in the year of conversion. Check your state tax situation again. A Roth conversion could lead to a higher tax bracket and more taxes for the respective year. You need to weigh those taxes against the potential never to pay income taxes on the funds again. Unlike the traditional IRA, Roth IRAs are not subject to required minimum distributions. You will not be forced to take money from your Roth while you are alive.

So why consider a Roth IRA now? In today’s environment of relatively lower tax rates, this might make sense. Assuming tax laws don’t change, the lower tax rates will expire in late 2025. Increasing deficits due to the pandemic can later lead to higher tax rates. Taxes are the big unknown. Switching to a Roth IRA can make sense if you think you are in a higher tax bracket when withdrawing funds. Traditional IRAs may make more sense if you think your tax bracket is lower when using the funds.

If your traditional IRA investments have depreciated, the conversion may cost you less tax. You may have had financial challenges this year that could result in lower income. Lower incomes and thus lower tax rates can mean that there is more room for conversion before switching to the next tax bracket. It is important to consider how you will pay the taxes generated by the conversion. The Roth conversion strategy works best when you have other means of paying the tax due and not using any part of the traditional IRA distribution to cover it.

The end of the year is getting closer. This is a strategy to consider that could benefit your financial picture in the future. It may be advisable to discuss your options with a certified financial planner who is familiar with your individual situation.