Should You Convert Your IRA to a Roth IRA?

Should You Convert Your IRA to a Roth IRA?

by on July 28, 2016

The Roth IRA has grown in use and popularity among investors, financial planners, and CPA practitioners since its creation in August of 1997. Many times, converting your IRA to a Roth IRA can substantially reduce your income taxes over a long-term horizon. Is it right for you?

Why use a Roth IRA? Put simply, to save income taxes. Earnings withdrawn from a Roth IRA are exempt from income taxes (provided they meet some IRS rules that are not too burdensome for retirees). The attraction of tax-free distributions does come with a cost. When you contribute funds to a Roth IRA, you are not allowed a deduction for the contribution, like you get when you contribute to a traditional IRA. (FYI, the same is true for §401(k) accounts and Roth §401(k) accounts.) Also, if you convert funds from a traditional IRA to a Roth IRA, the tax is due the year of the conversion.

So, as the old adage goes, “Pay now, or pay later.”

Given this issue, it is usually better to consider the use of a Roth IRA if you expect your future income tax rates to be higher than your current rates. (Otherwise, there is no real difference between the traditional IRA and the Roth IRA).

What are some scenarios where using a Roth IRA (usually through converting an IRA to a Roth IRA) is beneficial because you expect tax rates to be higher when you withdraw the money?

Here are three we encounter frequently:

1. Retirees younger than the age of 70½ with significant IRA balances. Your future income tax rate might be higher due to the Required Minimum Distribution (or “RMD”) rules. The income tax rules impose mandatory distributions from an IRA starting at age 70½. Each year, your RMD is larger than the last as a percentage of the previous year’s balance. Many retirees’ living expenses are below the RMD amount, but they are still required to take a higher distribution just to satisfy the rules. As the RMD grows each year, there is a tendency for your income to be subject to higher tax rates, simply because the rules required a distribution. Let’s say you are comfortably in the 15% income tax bracket with your retirement income today. In the not-too-distant future, you may find yourself in the 25% bracket by operation of these rules. Converting your IRA to a Roth IRA before these rules apply to you (that is, before age 70½) may help eliminate or substantially reduce this amount. Roth IRA balances are not subject to the RMD rules (at least not yet, but this may change in the future). The more you can convert from your IRA to a Roth IRA before these distributions occur, the more likely you are to avoid this bracket creep effect later in retirement. The tax savings over the course of your retirement can be substantial.

 

2. Families considering the use of a special needs trust for a loved one. Your future income tax rate might be higher if you are leaving assets to fund a special needs trust. Special needs trusts are designed to shelter assets from means testing in Medicaid and Supplemental Security Income paid to disabled individuals and children. They accumulate assets and make distributions for needs not covered by the government benefits. A very expensive income tax problem arises if the assets used to fund your trust are in a traditional IRA. An inherited IRA (what your traditional IRA will be when you pass away and the beneficiary receives the account) is required to make RMD payments to the beneficiary – in this case, the special needs trust. If the trust doesn’t need to make a payment for the disabled person, it accumulates the money. As it accumulates, the trust pays tax on the RMD from the IRA, except at a much higher rate. The rate tops out at 39.6% with just over $12,000 of taxable income. To combat this incredibly high rate of tax, consider converting your traditional IRA to a Roth IRA before the trust inherits the account in the higher brackets. Distributions from the Roth IRA will not be taxable in the special needs trust.

 

3. Families of children earning a significant income subject to high income tax rates. It is common for parents to plan to designate children as beneficiaries of their IRAs. In many situations, this is easy; and the income tax rates of the parents and adult children are the same or close. However, in other cases, the children may earn a substantial income and pay tax at a much higher income tax rate. If this is true for you, consider converting your IRA to a Roth IRA and allowing your children the benefit of inheriting the assets without income tax consequences. They may inherit a smaller IRA balance in many cases, but they keep more due to the tax-free nature of the distributions. The flip side of this is true as well. If the parents’ income tax bracket is higher than their children’s anticipated income tax rate, you would NOT want to convert to a Roth IRA.

 

These three uses are our most frequent uses of Roth IRA accounts, apart from normal savings. There are other benefits and possible pitfalls of using Roth IRAs. Also, be careful not to convert so much of your traditional IRA in one year that you “enjoy” a high bracket early.

PlanFIRST is a fee-only investment advisor dealing in both retirement and non-retirement portfolios.

Should You Convert Your IRA to a Roth IRA?

by on July 28, 2016

The Roth IRA has grown in use and popularity among investors, financial planners, and CPA practitioners since its creation in August of 1997. Many times, converting your IRA to a Roth IRA can substantially reduce your income taxes over a long-term horizon. Is it right for you?

Why use a Roth IRA? Put simply, to save income taxes. Earnings withdrawn from a Roth IRA are exempt from income taxes (provided they meet some IRS rules that are not too burdensome for retirees). The attraction of tax-free distributions does come with a cost. When you contribute funds to a Roth IRA, you are not allowed a deduction for the contribution, like you get when you contribute to a traditional IRA. (FYI, the same is true for §401(k) accounts and Roth §401(k) accounts.) Also, if you convert funds from a traditional IRA to a Roth IRA, the tax is due the year of the conversion.

So, as the old adage goes, “Pay now, or pay later.”

Given this issue, it is usually better to consider the use of a Roth IRA if you expect your future income tax rates to be higher than your current rates. (Otherwise, there is no real difference between the traditional IRA and the Roth IRA).

What are some scenarios where using a Roth IRA (usually through converting an IRA to a Roth IRA) is beneficial because you expect tax rates to be higher when you withdraw the money?

Here are three we encounter frequently:

1. Retirees younger than the age of 70½ with significant IRA balances. Your future income tax rate might be higher due to the Required Minimum Distribution (or “RMD”) rules. The income tax rules impose mandatory distributions from an IRA starting at age 70½. Each year, your RMD is larger than the last as a percentage of the previous year’s balance. Many retirees’ living expenses are below the RMD amount, but they are still required to take a higher distribution just to satisfy the rules. As the RMD grows each year, there is a tendency for your income to be subject to higher tax rates, simply because the rules required a distribution. Let’s say you are comfortably in the 15% income tax bracket with your retirement income today. In the not-too-distant future, you may find yourself in the 25% bracket by operation of these rules. Converting your IRA to a Roth IRA before these rules apply to you (that is, before age 70½) may help eliminate or substantially reduce this amount. Roth IRA balances are not subject to the RMD rules (at least not yet, but this may change in the future). The more you can convert from your IRA to a Roth IRA before these distributions occur, the more likely you are to avoid this bracket creep effect later in retirement. The tax savings over the course of your retirement can be substantial.

 

2. Families considering the use of a special needs trust for a loved one. Your future income tax rate might be higher if you are leaving assets to fund a special needs trust. Special needs trusts are designed to shelter assets from means testing in Medicaid and Supplemental Security Income paid to disabled individuals and children. They accumulate assets and make distributions for needs not covered by the government benefits. A very expensive income tax problem arises if the assets used to fund your trust are in a traditional IRA. An inherited IRA (what your traditional IRA will be when you pass away and the beneficiary receives the account) is required to make RMD payments to the beneficiary – in this case, the special needs trust. If the trust doesn’t need to make a payment for the disabled person, it accumulates the money. As it accumulates, the trust pays tax on the RMD from the IRA, except at a much higher rate. The rate tops out at 39.6% with just over $12,000 of taxable income. To combat this incredibly high rate of tax, consider converting your traditional IRA to a Roth IRA before the trust inherits the account in the higher brackets. Distributions from the Roth IRA will not be taxable in the special needs trust.

 

3. Families of children earning a significant income subject to high income tax rates. It is common for parents to plan to designate children as beneficiaries of their IRAs. In many situations, this is easy; and the income tax rates of the parents and adult children are the same or close. However, in other cases, the children may earn a substantial income and pay tax at a much higher income tax rate. If this is true for you, consider converting your IRA to a Roth IRA and allowing your children the benefit of inheriting the assets without income tax consequences. They may inherit a smaller IRA balance in many cases, but they keep more due to the tax-free nature of the distributions. The flip side of this is true as well. If the parents’ income tax bracket is higher than their children’s anticipated income tax rate, you would NOT want to convert to a Roth IRA.

 

These three uses are our most frequent uses of Roth IRA accounts, apart from normal savings. There are other benefits and possible pitfalls of using Roth IRAs. Also, be careful not to convert so much of your traditional IRA in one year that you “enjoy” a high bracket early.

PlanFIRST is a fee-only investment advisor dealing in both retirement and non-retirement portfolios.


Should You Convert Your IRA to a Roth IRA?

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