As you head into retirement, it’s a good idea to start thinking about how you plan to manage the tax consequences of accessing your nest egg. If you have money in a traditional IRA, the IRS will require you to start taking distributions starting when you’re 70 ½ to ensure it gets its fair share of the money you’ve been growing tax-free up to that point. Instead of allowing IRS rules to be your default tax strategy, it may be worth looking at whether converting some part of your traditional IRA to a Roth IRA will allow you to come out ahead.
As a refresher, traditional IRAs are tax-deferred. That’s income you’ve never paid taxes on that will be taxable as soon as you withdraw it. Roth IRAs, by contrast, are made up of post-tax dollars. Both the principle of Roth IRAs and their gains will never again be liable for income tax.
Deciding whether to make the conversion, hence, is a matter of timing when you want to pay your tax bill: Now with a Roth conversion, or later, with a traditional IRA. If you are earning a lot of money now, it’s probably best to sit tight with your traditional IRA. But if you are in an acceptably low tax bracket, paying those taxes now means you can access a suite of benefits going forward:
A tax-free income source. Once you are age 59½ and have owned a Roth IRA for five years, both the principle you contributed to your Roth and its gains aren’t taxable. This means that you’ll be all set if you need additional funds in a given year but don’t want the tax liability.
Tax-free capital gains. One of the primary benefits of converting to a Roth IRA is that because you pay tax on your conversion, you don’t have to pay taxes on the money ever again. This means you can watch your IRA funds grow indefinitely without ever paying taxes on withdrawals.
The ability to keep contributing. You can contribute to a Roth IRA as long as you live, unless you lack earned income or make too much money to do so. The 2016 contribution limit is $5,500, with an additional $1,000 “catch-up” contribution allowed for those 50 and older.
No more mandatory distributions on that money. Since you’ve already met your tax obligation on Roth money, the IRS doesn’t care when you decide to take distributions. This means you have more control over your tax-bill, and, by extension, over how much money you hand to Uncle Sam.
A tax free-legacy. Roth IRAs can prove to be very useful estate planning tools. Roth IRA heirs can end up with a tax-free inheritance, paid out either annually or as a lump sum. While your heirs must take annual RMDs, they won’t be subject to any federal taxation on those withdrawals if the account has been opened for at least 5 years. In contrast, distributions of inherited assets from a traditional IRA are routinely taxed.
Deciding how (and when) to proceed
The first consideration of a Roth conversion is whether you’re prepared to pay the taxes of a conversion this year. When you add the taxable income from the conversion into your total for a given year, you could find yourself in a higher tax bracket. One way you can offset the tax impact of is by doing partial conversions from year to year instead of one big conversion. This could be a good idea if you are in one of the lower tax brackets and like to itemize deductions.
Another consideration is whether any of the drawbacks of Roth IRAs will impact you. For example, you will generally be hit with regular taxes plus a 10% penalty by the IRS if you withdraw Roth IRA funds before age 59½ or you haven’t owned the IRA for at least five years. Two, you can’t deduct Roth IRA contributions on your 1040 form as you can do with contributions to a traditional IRA or the typical workplace retirement plan. Three, you might not be able to contribute to a Roth IRA as a consequence of your filing status and income; if you earn a great deal of money, you may be able to make only a partial contribution or none at all.
Fortunately, if you find that the conversion hasn’t benefited your portfolio as planned, you can undo it by “recharacterizing” the conversion. If a newly minted Roth IRA loses value due to poor market erformance, for example, you may want to do it. The IRS gives you until October 15 of the year following the initial conversion to “reconvert’’ the Roth back into a traditional IRA and avoid the related tax liability.
As always, when making the decision whether to move forward with a Roth conversion or with any other tax move, it’s a good idea to coordinate with your tax and financial professionals.