The past few months have been filled with many challenges from both an economic and social perspective. Stay-at-home orders, social distancing, rising unemployment levels, and overall economic uncertainty can cause stress and uncertainty. However, there are some opportunities available to grow wealth during this time. Disclaimer: This information is not to be considered tax advice and none of the information provided here should be acted on without consulting a tax and/or financial advisor.
If your Traditional IRA portfolio has taken a hit, or if your income will be lower this year than in previous years, it may be a good time to consider converting a part or all of your Traditional IRA to a Roth IRA. This technique is commonly referred to as a Roth conversion. A Roth conversion entails paying income tax on any amount of the IRA that is converted the year of the conversion. Your age and source of funds to pay the taxes are among multiple factors in determining if this strategy is right for you.
The benefits of owning a Roth IRA are as follows:
- Roth IRAs grow income and capital gains tax-free, assuming all distributions are qualified. Federal tax rates are currently near historic lows and there is a chance that they will be higher in the future. Traditional IRAs are only tax-deferred, meaning you must pay income tax on each qualified distribution at ordinary income tax rates. All qualified distributions from a Roth IRA are exempt from taxation.’
- Roth IRA’s have no Required Minimum Distributions (RMDs) during the Roth IRA owner’s life. With a traditional IRA, RMDs are required starting at age 72. RMDs are calculated according to the size of the IRA and calculated life expectancy tables published by the IRS. These distributions create a taxable event, which may not be ideal if you are still employed or in a high tax bracket.
- A Roth Conversion circumvents the income requirement to contribute to a Roth IRA. As of 2020, contributions to a Roth IRA are phased out for single filers who have a Modified Adjusted Gross Income (MAGI) of $124,000 or higher and restricted for those who have a MAGI of $139,000 or higher. For those who are married and file jointly, these limits are $196,000 and $206,000 respectively. However, those who convert from a traditional IRA are exempt from contribution limits.
- A Roth IRA helps to maximize generational wealth transfers. As stated above, Roth IRAs are not subject to RMDs during the owner’s lifetime, which allows your assets to grow tax-free. However, upon the owner’s death, non-spouse beneficiaries of Roth IRAs are required to take minimum distributions similarly to an Inherited traditional IRA. Non-spouse Inherited IRA assets must be fully withdrawn within 10 years of the death of the original account holder. The key difference is that the minimum distributions for the Roth IRA are still completely tax-free for the beneficiary (assuming the account was open 5 years before the owner’s death), thus increasing their wealth.
This strategy works best when taxes due on the converted amount are paid by a source other than the Traditional IRA that is being converted.
Note: If you are a parent and your child has a traditional IRA and you intend to leave them a large amount of assets upon your death, you may consider gifting the taxes owed for your child’s conversion now as part of your gifting strategy and estate plan. Likewise, if you have a traditional IRA and are expecting a large inheritance, it may be worth a conversation with your parents regarding gifting some of those assets now to cover the conversion tax while removing assets from their estate.