by Roth conversion creates a taxable event in the year of conversion. For that reason, it’s critical to address each and every tax and planning detail with a knowledgeable tax advisor. Here are some of the key points to bear in mind when considering a conversion:
- Turn Lemons into Lemonade: Utilize Losses to Offset the Tax on the Conversion:
Have you experienced a drop in income and expect your income to recover next year? Have you found yourself between jobs and will only work a portion of the year? Net operating loss carryforwards, charitable contribution carryforwards, non-refundable tax credits, and pass‐through losses could reduce, and in some cases, even eliminate, the associated tax liability. Individuals who experience a large income drop can use the temporarily low marginal rate to convert at a lower rate.
- A Word about Penalties, RMDs and Indirect Rollovers:
Conversion transaction in and of itself does not trigger a premature IRA distribution penalty, even if you are younger than 59½. However, when paying taxes with your IRA assets, be aware of the 10 percent penalty applicable to distributions prior to age 59½. Converting to a Roth IRA and then taking a distribution out of the Roth does not relieve you from the 10 percent penalty.
Required minimum distributions (RMDs) cannot be converted. If you are 70½ or older, you must take your current year RMD before proceeding with a conversion.
The ideal way to move money from your traditional IRA to a Roth IRA is by means of a direct rollover, through a trustee-to-trustee transfer or an internal conversion. In this type of a transaction, instead of you receiving a check, funds are transmitted from one institution to another or from one account into another. If you do end up with a check from your IRA, as is the case with an indirect rollover, you must deposit it into another retirement account, such as a Roth IRA, within 60 days. Failure to do so will result in negative tax consequences and will prevent you from ever rolling over or converting the funds. If you do find yourself missing this important deadline, you can request that the IRS give you a pass, but it is usually a costly and unsuccessful endeavor.
- The 5-Year Clock and Access to Funds:
Need to access your retirement money within the next five years? Be careful with the conversion strategy. Roth dollars only become entirely tax‐free after meeting both of the following conditions: 1) it has been five years since the initial Roth deposit or conversion, whichever applies to the amount in question, and 2) you have met a qualifying event such as turning age 59½. Each conversion is subject to its own five-year window.
- Multiple IRAs? Non-Deductible Contributions? Handle with Care!
If you have a non-deductible IRA and wish to convert that account to a Roth, ordinary income taxes are only owed on earnings converted to your Roth IRA. However, you cannot convert only the non-deductible portion of an account and leave the taxable portion behind. The income recognized from your conversion is calculated by first looking at the percentage of the account that is non-deductible and then multiplying that percent by the amount of the conversion.
- Your Conversion Can Be Undone:
You have until October 15 of the year following the conversion to reverse it. This reversal is known as a re-characterization. To make the most of this strategy, your conversion amount is divided among separate Roth IRAs (e.g., one per asset class). By April 15 following the year of conversion, tax is paid on the entire amount converted and your tax return is extended. By October 15, the underperforming accounts are re-characterized and a tax return reporting conversions and re-characterizations is filed. Ordinary income tax associated with the re-characterized assets is eliminated. This planning mechanism offers a measure of downside protection. It is mostly cost-effective for larger IRA balances. The ability to re-characterize only underperforming assets is not available if all converted assets reside in one account. The IRS requires all gains and losses be prorated over the entire account balance.
- Beware of Shortcuts:
If you are considering a rollover from your employer’s plan directly to a Roth IRA, you need to know that you may be limiting your options when it comes to reversing this transaction. A re-characterization may only be made when a traditional or rollover IRA is converted to a Roth IRA. A re-characterization may not be made when the conversion is from a 401(k) (or any other qualified plan) to a Roth IRA. By transferring the funds into a rollover IRA first, you retain the ability to re-characterize.
- Ineligible for Contributing to a Roth IRA? There is a Way!
To make contributions directly to a Roth IRA, you must have income below a certain range. Check with your advisor to see what this year’s limits are. The conversion rule effectively allows anyone, even those who are married filing separately, to make a Roth IRA contribution despite the phase-out rules. Here’s how: Anyone who has compensation and is younger than 70½ may make a traditional IRA contribution. Factors such as eligibility to participate in an employer’s plan and income levels determine traditional IRA deductibility, not whether a contribution may be made, and that non-deductible IRA could immediately be converted to a Roth. If you have other IRA accounts, the taxable income resulting from this transaction will be computed based on their total value. Refer to fact No. 4 for additional details.
- Conversion May Help You Reduce Tax on Social Security Income:
Your Social Security dollars can be partially taxed if your income is above a certain threshold. Distributions from traditional IRAs are added in when determining your income for this purpose. Distributions from Roth IRAs are not included, potentially helping you reduce the income tax bite even more.
- A Roth Conversion May Increase the After-Tax Value of Your Estate:
If you do not need Roth accumulations and wish to leave a financial legacy, you may find Roth accounts indispensable. Roth accounts grow tax-free and RMD-free until the day they are turned over to your heirs. A surviving spouse can continue the tax-free and RMD-free pattern. Non-spouse heirs (children, grandchildren, etc.) can extend the Roth’s benefits by taking tax-free minimum distributions over their life expectancies, leaving the bulk of the account intact to continue tax-free growth.
- Final Thoughts:
Every cloud has a silver lining. Market corrections or pass-through losses may substantially reduce the tax cost for converting to a Roth IRA. Roth conversion provides you with an opportunity to gain control over how your retirement income will be taxed and can increase the amount left to heirs. Analyzing whether a conversion is beneficial to you involves many factors and assumptions including pre-and post-retirement tax brackets and rates of return, withdrawal rates, life expectancy, and estate tax rates.
We welcome the opportunity to work with you and your tax professional to carefully consider these factors and aid you in you in this important decision.