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This year and maybe next year could prove to be the best time in a long time to convert a traditional IRA to a Roth IRA. This is primarily due to the widespread belief that higher income and estate taxes are likely to be levied over the next year or two. In addition, stealth taxes such as social security taxation and Medicare premium taxes are likely to be increased or supplemented by new stealth taxes.
To maximize after-tax wealth, you will need to reassess the switch decision each year throughout the year. There are also certain events and situations that can increase the usefulness of a conversion. When these events occur, even if you have studied them carefully in the past and decided not to convert, take a close look at the conversion decision.
Here is an overview of the situations and events where a conversion is likely to be more profitable.
Not enough tax diversification. I urge everyone to diversify for tax purposes. This means that there are fixed assets in each of the three types of accounts that have different tax consequences: taxable accounts, traditional IRAs and other deferred tax accounts, and Roth IRAs and other tax-exempt accounts.
None of us can know what the tax law will look like in the future or how it will change over time. It is best to hedge your bets by having funds in any type of account. That way, you don’t run the risk of the after-tax value of all your investments being significantly reduced by changes in the tax code. Instead, some accounts will be hurt more than others. Some might even benefit from changes.
With tax diversification, you can also practice managing tax brackets in retirement.
Bracket Management gives you control over your retirement tax rate as you have a lot of control over what money you are spending. In a year that you are in a low tax bracket, take more money from the traditional IRA. If you’re already in high brackets or don’t want to jump into the next tax bracket, take tax-free distributions from a Roth IRA. In other years, you may want to keep the overall tax burden low by deducting long-term capital gains from a taxable account.
If you haven’t already invested in a Roth account, it is often a good idea to convert some traditional IRA assets into a Roth IRA.
Expect higher tax rates. If you believe that in the future you will have a lower tax rate than you have today, an IRA conversion is less convincing. However, the switch is more powerful if you want to pay a higher tax rate in the future. It might be better to pay tax at the lower rate today than at the higher rate in the future.
There is no IRA money to pay taxes. If you convert all or part of a traditional IRA into a Roth IRA, the converted amount will be included in gross income as if it had been distributed to you. Taxes on income are due on the converted amount.
You can pay income taxes with your non-IRA money. You can also make a distribution from the IRA to pay the taxes. That distribution would also be included in your gross income and you would pay tax on it. In essence, you pay taxes on your taxes.
If you do the math, a conversion is much more likely if the income tax is paid from a source other than the IRA. There are a few exceptions, e.g. B. if you expect to be in a much lower tax bracket in the future, or it will be a long time before you receive a distribution from the Roth IRA. Most of the time, however, you should have non-IRA money available to pay the taxes on the conversion.
There is after-tax money in the IRA. You may have made non-deductible contributions to an IRA or contributions to a 401 (k) that were included in gross income. This is after-tax money and is not taxed on distribution. Capital gains and profits that affect after-tax contributions are taxed as ordinary income on distribution, even if they are long-term capital gains or qualifying dividends.
You don’t pay tax when the after-tax money is converted into a Roth IRA in a traditional IRA. And in the future, when income and profits compounded in the Roth IRA are distributed, they will be tax free.
Unfortunately, you cannot just convert after-tax money that is in a traditional IRA. If you have both after-tax and pre-tax money in a traditional IRA, and not converting the entire IRA, the amount you convert will be considered both after-tax and pre-tax money in the same ratio that they were in the IRA before the switch. If you have multiple traditional IRAs, even if you are converting from just one of the IRAs, they are combined into one IRA to determine the post-tax and pre-tax share of the money.
If a high percentage of your IRA balance is pre-tax funds, making the switch is an easy decision.
Your estate may be taxable. An IRA, whether traditional or Roth, will be included in your gross estate and may be subject to estate tax.
If your beneficiary inherits a traditional IRA or 401 (k), the beneficiary will be taxed on distributions exactly as you would have been. The beneficiary actually only inherits the post-tax value of the traditional IRA.
So the traditional IRA may be taxed twice. There is inheritance tax and then income tax on the beneficiary when the IRA is distributed.
However, if you convert the traditional IRA to a Roth IRA, you will pay income tax for the conversion. This reduces the value of your estate by the amount of income tax. It also means that your beneficiary does not owe any income tax on dividends from the Roth IRA.
You essentially gave the beneficiary a tax-free gift by converting the IRA and paying the income taxes.
The taxable income this year is low. The decision on whether to convert all or part of a traditional IRA should be reviewed every year as your tax situation may change. If your income tax bracket is dropping, it’s a good time to switch part of your IRA.
Future RMDs are likely to be high. Minimum Required Distributions (RMDs) of IRAs and 401 (k) start after age 72. According to the life expectancy plan used to determine RMDs, the percentage of account distributed increases each year.
Many retirees have sufficient incomes and assets outside of their IRAs that they do not need the full RMD to cover their living expenses. Over the years the higher RMD creates income tax problems.
One way to avoid the problems with high RMDs is to convert a traditional IRA, in whole or in part, into a Roth IRA, as the original owner of a Roth IRA does not need to extract RMDs from it. For best results, the conversion is done years before the problem of RMDs, but conversions later can also be beneficial.
Converting a traditional IRA to a Roth IRA is not always for everyone. Re-evaluate the decision regularly and look out for situations that can make a conversion more profitable.