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Posted on April 9, 2018

Roths Rule! Consider a Conversion to Pay Less Taxes on Distributions

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Published by Taylor Financial Group

Whether your retirement date is a couple of decades away or you’re  leaving the working world in the next couple of years, nobody wants to pay more taxes than necessary on a distribution from their IRA.

  But have you carefully considered how much money you will need to pay in taxes when you make those withdrawals? While this question may seem like something to only think about in the distant future, it’s an important question to be asking yourself right now.

Many people contribute to a Traditional IRA (where your contributions are made with before tax dollars).  When the day comes to retire and you need to take withdrawals, your funds will be taxed as ordinary income based on your current tax rate at that time.  In a Roth IRA, contributions are made with after tax money and in retirement can be withdrawn tax free. To start a Roth IRA, you may be subject to certain income restrictions – for instance a twenty-four-year-old who files her taxes as a single filer must make less than $120,000 per year to contribute to a Roth. But, if your income exceeds the cap, you can always open a Traditional IRA and then convert it to a Roth IRA!

According to The Washington Post, tax brackets are now historically low so it could be a good time for that Roth conversion.  In fact, the new Tax Act passed in the late days of 2017 lowered many income brackets.  So, if you are a taxpayer filing married jointly making a combined salary of $98,000, your tax rate in 2017 was 25%, but due to the new legislation, your rate is now 22%.  Given these lowered tax brackets, now may be the time to consider a conversion of your Traditional IRA to a Roth IRA because you will owe taxes the year that you complete the conversion.  Another question you may be asking yourself is “can I pay the taxes on a conversion?”  If the tax bill is overwhelming, consider converting smaller portions of your Traditional IRA to a Roth IRA over a series of different tax years to spread out your tax liability.  You could even convert just enough funds so that you don’t get pushed out of your current bracket.

Of course, not everyone should convert to a Roth IRA.  If you are unable to pay the income taxes with your current cash flow, you should reconsider this move.  Also, it’s generally not advisable to use your Traditional IRA funds to pay the taxes on the conversion.  Furthermore, avoid selling non-retirement investments to pay the taxes on the conversion that have been held for less than one year as you will most likely incur short-term capital gains, which are taxed as ordinary income.  Finally, if you think you will need to use your Roth IRA funds in the next year, it may not be beneficial to convert these funds as these monies need to be in a Roth IRA for five years to receive the tax free benefit on any earnings.  But, if you are hoping to leave a legacy for your children, a Roth IRA is perfect as you are not required to take RMDs from the account.

If you are thinking of converting your traditional IRA to a Roth IRA, make sure you carefully plan the conversion.  Prior to the new Tax Act, if you made a conversion, you could ‘recharacterize’ your funds back to a Traditional IRA before October 15th of the next year.  This old rule was attractive if you converted your funds and then the market went down.  For example, you converted $50,000 into a Roth IRA and your account was worth $38,000 after a market downturn.  In this scenario, you would have paid tax on $50,000, so it would make sense to recharacterize and pay tax on the lower value.  In 2018, recharacterizations are no longer allowed.  According to the financial expert Ed Slott, many people will be converting their assets at year end to “find the sweet spot” so that they can see how the markets are performing and will “have a clearer picture of what their income” will ultimately be for the full year.  Although a Roth IRA may not be perfect for everyone, it is still an amazing accumulation and estate planning strategy.  Let us know if you have any questions.

 

Sources:

Money.Com, Make This One Change to Your Retirement Account Now, Tax Experts Say, March 2018.

The Washington Post, Your Taxes are Really Low, In One Chart, April 2014.

Converting from a traditional IRA to a Roth IRA is a taxable event. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal or earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59 ½ or due to death, disability, or a first-time home purchase (up to a $10,000 lifetime maximum). Depending on state law, Roth IRA distributions may be subject to state taxes.

Securities offered through Cetera Advisor Networks LLC, Member FINRA/SIPC. Investment advisory services offered through CWM, LLC, an SEC Registered Investment Advisor. Cetera Advisor Networks LLC is under separate ownership from any other named entity.

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