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The $ 11 trillion Americans saved on traditional individual retirement accounts (IRAs) are some kind of mirage.
“I tell clients with money in traditional IRAs not to fall in love with their balances too much because it isn’t theirs,” said Greg Hammer, founder of a wealth management firm in Schererville, Indiana. “I need to remind you that it is you or your spouse or children will owe income tax on that money. “
A Roth IRA conversion, where you transfer money from a traditional IRA to a Roth IRA, can be a smart way to manage your tax bill. But there are a number of moving parts that you need to get to grips with before doing a Roth conversion.
What is a Roth IRA Conversion?
At first glance, a Roth IRA conversion is exactly what it sounds like: you’re moving your retirement assets from a traditional IRA to a Roth account. That way, you can prepay your tax bill sooner rather than later.
Any money you convert will benefit from the benefits Roth IRAs have to offer, such as: B. Tax-free growth. No matter how much your Roth IRA grows in value, you won’t owe a penny in taxes in retirement. Until then, however, you can withdraw all of the money you are converting with no penalty or tax, as long as it has been at least five years since you converted it.
Once you’re 72, you’ll also avoid the hassle of mandatory minimum withdrawals known as Minimum Payouts (RMDs). This will make your money grow even longer.
“Customers keep looking at me and asking why they should spend $ 25,000 today to convert a traditional $ 100,000 IRA,” said Hammer. “And I ask them if they want to pay the tax now or if the money should keep growing and owe RMDs for a larger balance in years.”
Advantages of a Roth IRA conversion
Once you have converted the retirement savings into a Roth IRA, you have more options to manage your tax burden in retirement. This includes:
• Get rid of RMDs. If you have money in a traditional IRA, you must start withdrawing RMD as soon as you are 72 years old. It doesn’t matter whether you need the money or not. The IRS insists on the payout so that it can collect income tax on every dollar withdrawn. Switching to a Roth IRA can avoid this so that every penny that grows can be left to your heirs if you so choose.
• • Money withdrawn from a Roth IRA can be tax-free. The money you convert (and pay tax on) can be withdrawn without paying income tax at any time and at any age. But – there always seems to be a tax law – if you are younger than 59½ years at the time of conversion, you will have to wait five years to avoid a 10% early withdrawal penalty. This applies separately to each conversion you make. So if you do a Roth conversion twice in different years, you will need to run two five-year clocks. There is also another five-year rule to keep in mind: your account must have been topped up at least five years ago in order to receive tax-free profit withdrawals. This is true regardless of your age.
• Smaller RMDs on your remaining traditional retirement accounts. You don’t have to convert all of the money from a traditional IRA into a Roth IRA. Partial Roth conversions are often tax-related (more on that later). Regardless of what amount you convert before you turn 72, there is less money left behind in your traditional IRA, which effectively means you will have to use less money than RMD later on.
• Lower taxable income can reduce other retirement costs. If you are tied to RMDs, these withdrawals are considered taxable income. Reducing your RMD burden means less taxable income in retirement and can help you control other retirement costs. Your Medicare Part B premium and whether you owe tax on Social Security benefits – and how much – are based on taxable income.
• A cover against your tax rate, which is no lower in retirement. If you expect your annual income from retirement sources – RMDs from traditional accounts, social security, and possibly a pension – to be not significantly less than your current income, it reduces the likelihood that you will receive a lower tax rate later. That could make it more attractive to convert now, pay the tax and then grow tax-free in the future. And while there is absolutely no way of predicting what the tax rates will be when you retire, let alone five, ten, and 20 years after you retire, having some retirement savings is worth considering before that is immune to the possibility of higher tax rates.
• Easier for your heirs. Almost anyone other than a spouse who inherits an IRA must clear the account within 10 years of the year they passed away. If it’s a large traditional IRA, it can create a tax headache. You will still have to withdraw all the money in an inherited Roth IRA 10 years from now, but you will not owe any taxes – and this will not affect your taxable income level.
Disadvantages of a Roth conversion
• You expect your income to be much lower in retirement. If you are in a high tax bracket today, it may not make sense to pay the tax on a Roth IRA conversion.
• You don’t have the money to cover your tax bill. You don’t want to use Roth IRA conversion money to pay the tax. The goal should be to keep the money growing tax-free for as long as possible. You shouldn’t make a Roth IRA conversion a priority either if you have high-yield credit card debt or need to dive into your emergency fund.
• You plan to move to a country with lower taxes. “If you currently live in a state where conversion is taxed and plan to move to a state where retirement income is not taxed, it may make sense to wait until you move,” says Brian Kennedy , President of KCA Wealth Management in Camp Hill, Penn.
• You expect your family to apply for college financial assistance. Money in a retirement account does not affect financial support. In the year you convert, the conversion amount will appear as income on your tax return. This could affect your family’s financial assistance package.
How to Perform a Roth IRA Conversion
The easiest way to do a Roth conversion is to have both accounts with the same financial institution. If you don’t already have a Roth IRA, but like the financial institution where your traditional IRA account resides, you can open a Roth IRA and then convert it with just a few clicks of the mouse.
If you want to convert a traditional IRA at Brokerage A to a Roth IRA at Brokerage B, there are a few steps involved. First, you need to open the Roth IRA at Brokerage B. Then tell Brokerage A that you want to do a direct rollover from trustee to trustee to Brokerage B and note how much of your balance you want to move.
In both scenarios, the brokerage firm where you park your converted Roth IRA will file a 1099-R with the IRS to report the taxable distribution. And if you’re filing your federal tax return for the year, you’ll need to report the distribution on Form 8606 as well.
You can also take a distribution from your traditional IRA as a check and then transfer the money to your new Roth account yourself. But that calls for trouble. If your self-managed rollover is not completed within 60 days, the entire amount will be treated as a taxable distribution. Granted, you would have paid tax on it anyway if you converted, but if you are under 59 ½ years old if you miss the 60 day window, you will also get a 10% early withdrawal fine.
How to manage Roth IRA conversion taxes
Given all the moving parts, it is worth considering working with a tax professional or financial advisor who is having serious problems understanding all of the moving parts.
You will likely want to consider a strategy that limits your conversion in any given year to an amount that doesn’t push you into a higher tax bracket. If you are retiring 72 years ago and have lower income, those years can be an ideal place to convert traditional IRA money into a Roth.
Working with a financial advisor can also discuss ways to offset the tax due on the conversion. Harvesting losses on investment accounts is one option. And when listing your federal tax return, consider investing more charitable donations – that qualify as a tax deduction – in a tax year when you will receive more taxable income from a Roth IRA conversion.
When does a Roth IRA conversion make sense?
By converting money from a traditional IRA to a Roth IRA, you can better manage your retirement tax burden and leave an easier financial legacy for your heirs.
When and how much to convert in any given year needs careful consideration as the conversion will increase your taxable income for that year. When considering a Roth IRA conversion, it may be best to consult a financial advisor or tax advisor with experience in Roth IRA conversions.