Are you thinking strategically about the possibility of higher taxes and their effect on your retirement assets? With the change of administration in the white house as well as a control shift in the senate, higher taxes are expected in the near future. However, a tax reform likely won’t go into effect before 2022, making this a key year to seriously consider whether a Roth IRA conversion is a good idea for your portfolio.
First, let’s define a Roth IRA. A Roth IRA is a retirement account that is funded with money you have already paid taxes on. There is no upfront tax break with a Roth IRA, but a Roth IRA does offer tax-free growth as well as tax-free withdrawals in retirement (as long as you have owned the account for 5 years and you are 59½ or older).
A Roth IRA Conversion is where you transfer assets from a tax-deferred retirement account, such as a 401(k) or traditional IRA, and move it into a Roth IRA. By converting assets while you are still working, you pay taxes with current income and allow the Roth IRA to continue to grow tax-free.
This may be important if, once you retire, you have income flowing in from multiple sources (e.g., 401(k), pension, Social Security), which ends up putting you in a higher tax bracket in retirement than when you were still working.
While this sounds like a simple process, there are some things you need to be aware of.
- If you are converting after age 72, you must still take your RMD from your tax-deferred account.
- All funds must be deposited into the Roth IRA within 60 days of distribution, otherwise, it is not considered a rollover conversion and may be subject to additional penalty taxes.
- You will owe taxes on any money that would have been taxed when you withdrew it. This includes tax-deductible contributions and tax-deferred earnings that have built up in the account over the years. This money will be taxed as income for the year you make the conversion.1
- Someone younger than 59 ½ who accesses the converted amount within five years of the conversion will have to pay an additional 10% early withdrawal penalty. If earnings on the converted amount are accessed, they are subject to both income tax and the extra 10% tax. Once five years have passed since the conversion, the extra 10% tax on the converted amount no longer applies.
- If you are in a lower tax bracket during retirement, converting assets could bump you into a higher tax bracket. Furthermore, the higher income level that year could cause your premiums to rise for Medicare Part B benefits and may subject a higher portion of your Social Security benefit to taxes.2
When considering a Roth IRA conversion, evaluate the potential breakeven point in which tax-free withdrawals and the ability to avoid RMDs outweigh the burden of paying taxes at the time of conversion. The answer may lie in comparing your current tax status to what you think your future tax status might look like. Like any financial strategy, the decision to conduct a Roth IRA conversion is based on individual circumstances, such as age, portfolio diversity, long-term goals, tax bracket, and the tax status of future heirs.
Everyone’s situation is different, and a Roth IRA Conversion may not be the right option for you. Please give us a call at 801-465-6990 if you have any questions or if you would like to talk more about your situation and see if 2021 is the right time to make this move.
1 Roger Wohlner. ThinkAdvisor. Jan. 5, 2021. “Roth IRA Conversions: What Advisors Need to Know.” https://www.thinkadvisor.com/2021/01/05/roth-ira-conversions-what-advisorsneed-to-know/. Accessed Feb. 15, 2021. 2 Jane Meacham. Financial Advisor. Feb. 1
2 Roger Wohlner. ThinkAdvisor. Jan. 5, 2021. “Roth IRA Conversions: What Advisors Need to Know.” https://www.thinkadvisor.com/2021/01/05/roth-ira-conversions-what-advisorsneed-to-know/. Accessed Feb. 15, 2021.
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