Roth IRA Conversion

Roth IRA Conversion

Traditional IRAs are widely understood to allow the investor to make tax-deferred contributions to the account now, and pay taxes on the contributions and earnings later in life when they are likely in a reduced tax bracket. However, the newer Roth IRA is less known and sometimes misunderstood.

The major difference of the Roth IRA is that it allows investors who are willing to forgo an immediate tax deduction the opportunity to enjoy tax-free distributions of the accumulated growth on those contributions at the time of distribution. The earnings on Roth contributions can be withdrawn from the account free from taxation or penalties once the account has been held for 5 years and the account owner is 59 1⁄2 or older.

This “tax free” feature makes the Roth IRA quite possibly the best savings vehicle known to mankind. Through the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA), eligibility rules that once barred higher wage earners from using the Roth were eliminated January 1, 2010.

You may be asking yourself, “Should I convert to a Roth IRA?” The answer is not so simple, and depends on several different factors. In fact, you may wish to consider a partial conversion or a series of annual partial conversions. The Roth conversion is a strategy that does not have to be “all or nothing.”

There are a variety of reasons an investor may be interested in the Roth conversion. The following are three typical situations in which a Roth conversion may be a good strategy.

Imagine, once you’re retired, not having to pay taxes on your retirement earnings when you withdraw them from your IRA. It’s possible with the Roth IRA. And the once limited-entry to this powerful savings tool is now open to a larger group of investors.

Situation – Down Market

  • Your IRA portfolio has suffered a substantial reduction of value.
  • You believe that the market will eventually recover.

Advantages of conversion:

  • You pay taxes on the value converted. Therefore, the taxable income generated by the conversion is much lower than would be the case if the conversion occurs when your IRA doesn’t have a depressed value.
  • If values continue to decline after the conversion, you may be able to recharacterize and reconvert to take advantage of the lower tax liability of the reconversion (deadline limitations exist).
  • Your IRA can be converted into several separate Roth IRAs in case recharacterization of specific assets (segregated in a separate Roth IRA) becomes desirable.

Questions to consider:

  • Do you believe the reduction of your IRA portfolio is due to market conditions that will reverse over time?
  • Can you pay the income taxes that will be generated by the Roth conversion with non-IRA funds?1

Situation – Tax Planning

  • Your interest in conversion is motivated by tax benefits that are either long term or short term in nature.
  • You firmly believe that future taxes will escalate, or you have the ability to offset increased income with tax credits, exemptions or deductions that would otherwise be lost. 

Advantages of conversion:

  • If you have unused tax credits, exemptions, deductions or ordinary losses, the Roth conversion would generate reportable offsetting income on a tax-advantaged basis.
  • You will not be forced to satisfy required minimum distributions, allowing more flexibility for tax planning of retirement distributions.
  • The advantage of tax-free growth may outweigh the current cost of any income tax caused by the conversion when you intend to delay retirement distributions until a much later date.

Questions to consider:

  • Do you have any business or other ordinary losses that could be used to offset the Roth conversion income?
  • Do you have charitable contribution carry- forwards that could be used to offset the Roth conversion income?
  • Do you have any unused deductions, exemptions or tax credits in the current tax year?
  • Do you intend to delay retirement withdrawals for at least the next 10 years?
  • Do you have a large percentage of your IRAs in after-tax dollars? (Pro-rata distribution rules).
  • Do you have a Roth 401(k) account in your qualified employer sponsored retirement plan (QRP) that you intend to roll to a Roth IRA when you retire? (The five year time period for tax-free distribution eligibility does not transfer from the QRP to your Roth IRA. If you do not already have a Roth IRA, the five year waiting period will start with this rollover.)
  • Can you pay the income taxes that will be generated by the Roth conversion with non-IRA funds?1

Situation – Wealth Transfer

  • You have more than sufficient retirement income and assets in addition to the IRA and you have a great desire to transfer wealth to the next generation.
  • You feel that transferring tax-free wealth to future generations is very important.

Advantages of conversion:

  • Payment of ordinary income tax on the conversion reduces the taxable estate.
  • Growth opportunity is substantial for beneficiaries due to the effects of tax-free compounding in the inherited Roth IRA as it is “stretched” over the beneficiaries’ life expectancies.

Questions to consider:

  • Have you named a trust as the beneficiary of your IRA assets?
  • Do you intend to leave all your IRA assets to your heirs?
  • Can you live comfortably in retirement without taking IRA distributions?
  • Can you pay the income taxes that will be generated by the Roth conversion with non-IRA funds?1

You may find one or more of these objectives is of interest to you. If so, please contact me so that you and I can begin to work with your tax and/or legal advisor to determine if a Roth conversion might make sense for you.

1 If you are not 59 1⁄2 at the time of conversion, you will be subject to an additional 10% early withdrawal penalty on any funds withdrawn from your IRA that are used to pay the taxes and are, therefore, not rolled into your Roth IRA.)

Securities and advisory services offered through J.J.B. Hilliard, W.L. Lyons, LLC, a registered investment advisor and broker dealer. Member NYSE, FINRA & SIPC. Investing in securities involves risk, including possible loss of principal. ©2018. All rights reserved.

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J.J.B. Hilliard, W.L. Lyons, LLC | Member NYSE, FINRA, & SIPC

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