Because of retirement-related federal legislation passed in the last few years, many individuals are considering converting some or all their traditional IRAs to Roth IRAs. One major reason is that most beneficiaries of traditional IRAs other than surviving spouses are no longer allowed to “stretch” distributions from their traditional IRA inheritances over their lifetime. The beneficiary must withdraw all the inheritance within 10 Years. Moreover, if the deceased owner of the IRA has begun taking yearly required minimum distributions (RMDs), then he/she must also take RMDs for years 1-9 based on the owner’s single life expectancy. For any distributions from a traditional or inherited IRA, the owner or beneficiary is required to pay ordinary income tax. If deceased owner had not started taking RMD, then the inheritance may be held till the end of the 10th year, if held to the end, the beneficiary face a very large income tax bill at that time.
For all these reasons, an owner of a traditional IRA who wants to minimize the future income tax liability for his/herself or heirs might consider converting traditional IRA funds to a Roth IRA. In addition to the tax advantages for heirs, the owner of the IRA, especially if he/she expects to live a long time, will receive the benefit of tax-free income and no capital gains tax on the Roth assets.
Qualified plans such as a 401(K), 403(B), 457 plans as well as a SEP and SIMPLE plan may be rollover too provided for in the companies plan before retirement. However, done before age 59 ½ there is a 10% IRS penalty on the amount rolled to a Roth.
On the other hand, all conversion amounts are taxable at ordinary income tax rates in the year of the conversion, so the owner must weigh the benefits against the immediate tax liability associated with the Roth conversion. Note, there are programs such as wealth link, right capital that help evaluate the tax impacts to the role the helping one informed decision.
The following summarize additional reasons not to convert:
–Inability to pay the tax bill: All Roth conversions are subject to immediate income tax liability in the year of conversion. Before you convert, you should estimate your income tax liability for that year. Under current tax regulations, you can’t change your mind after you convert; there is no re-characterization. If you are under 59 1/2, if you plan to pay the tax bill from an IRA account, you will be incurring a 10% penalty as well.
If there is a high possibility that emergency financial needs will arise, necessitating use of the funds you would otherwise use to pay your increased income tax bill, don’t convert.
– What is your current marginal tax rate – the rate over an IRA defined amount? Because of the current year tax liabilities associated with the amount of converted assets, IRA owners should consider partial conversions to avoid large tax liabilities in one year that could also increase their marginal tax bracket.
– What is your exposure to stealth taxes? When you convert, you are increasing your taxable income in the year of conversion, which can impact other taxes. For example, your Social Security taxes could increase. You could lose valuable tax credits and deductions because of higher income. Another consideration is the possibility of higher premiums for Medicare Part B and Part D two years after the year of your conversion.
–What do you anticipate future income tax rates to be higher or lower compared to your current tax rate? In general, conversions make more sense when you anticipate that the marginal tax rate at the time of your withdrawals will be more than your current marginal tax rate.
–Loss of college financial aid: Any additional income must be reported on financial aid forms such as FAFSA and CSS. This could reduce or even eliminate sources of financial aid.
–Losing future tax breaks: If you have been using qualified charitable distributions (QCD) to reduce your taxes, you will lose that advantage if you convert all your traditional IRAs to a Roth account. The QCD option is not available from Roth accounts.
–Charity as beneficiary: Qualified charities do not pay income tax on gifts from IRAs. If your objective is to leave some IRA funds to a charity, don’t convert these assets to a Roth. Why pay taxes on a Roth conversion if the charity would not pay taxes on a contribution from a traditional IRA account?
–Waiting time: After you convert from a traditional IRA to a Roth, there is a five-year waiting period before you can withdraw earnings tax-free from your Roth account (assuming you have reached 59 1/2). You can withdraw the principal amount you converted at any time tax-free without penalty even if you have not reached 59 1/2.
Bottom Line: There are definite advantages to you and your beneficiaries associated with Roth conversions. But there are some potential disadvantages that you must consider. It may be to your advantage to do partial conversions each year to avoid the higher taxes associated with higher marginal tax brackets, as well as other disadvantages.
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All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Sources: 1-compilation of articles, personal finance, December 23, 2022; Investopedia, Roth IRA conversion rules by G.3, March 23, 2023. “Roth Conversions” T Savage April 6 2023.
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