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Mar 2020
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March 10, 2020

Should I Convert My IRA to a Roth IRA?

As families learn the implications the SECURE Act will have on their estate planning, those intending to use IRAs to transfer wealth to the next generations may be looking for ways to ease the negative tax effects the new 10-year distribution rule would have on their beneficiaries (Sara Nicholson discusses this rule in her article, “The SECURE Act Provides Less Security for Beneficiaries”).  
 
Converting from a traditional IRA, which taxes withdrawals, to a Roth IRA, which taxes contributions rather than withdrawals, allows your beneficiary (who must drain the IRA within 10 years) to avoid a hefty tax bill, especially if distributions occur when the beneficiary is in prime earning years and already in a high tax bracket. However, it is important to weigh several factors before making a conversion.
 
What are the Benefits of a Roth IRA?
 
  1. No required minimum distributions (RMDs) during your lifetime: If you don’t need these regular distributions to fund your retirement lifestyle, your money can stay in the account and continue to grow tax-free.

  2. No tax on withdrawals: The money was taxed going into the account. If you meet the requirements for a qualified distribution (you are over 59 ½ and have had a Roth IRA open for more than 5 years), you will not pay tax on withdrawals of contributed assets or on the growth you earned on those assets. Withdrawals also do not increase taxable income, so they do not affect other income-sensitive tax items like the taxability of Social Security or the amount of your Medicare premiums.

  3. Leave money to your heirs tax-free: Although beneficiaries will still have to empty the account over a 10-year period, the withdrawals will be tax-free so they will not push beneficiaries into higher tax brackets.   
 
Is a Roth Conversion Right for Me?
 
  1. Will You See a Tax Savings by Converting?
    1. It makes sense to pay taxes on traditional IRA assets when you are in a lower tax bracket. Conversions tend to make sense for young savers who expect their income to climb later or for older individuals who have retired but are not yet experiencing the income increases from taking Social Security or RMDs. (Under the SECURE Act, you have an additional year or two before RMDs must start.)
    2. While no one knows whether tax rates will be higher when you start taking distributions, we do know that current tax rates are comparatively low, which may make now a good time for a conversion.
    3. Keep in mind that IRA withdrawals are also subject to state income tax. If you plan to move to a state with low or no state income tax (like Florida) before you start taking distributions from your IRA, consider whether that tax savings would make a conversion unwise.    
    4. If you anticipate significant medical expenses or other tax factors that might offset taxable income after you start taking RMDs, then the tax-free withdrawals of Roth IRAs have less value to you.

  2. Are You Well-Positioned to Pay the Tax Due on a Conversion?
    1. Because you will need to pay tax on all pre-tax IRA assets being converted (likely to be significant if the IRA funds were rolled over from an employer plan), a conversion could push you into a higher tax bracket, cause more of your Social Security benefits to be taxed, and increase your Medicare premiums.
    2. Consider spreading the conversion over multiple years. Your CPA can calculate how various conversion amounts and schedules would affect current and future tax bills.
    3. If you cannot pay the tax on the conversion without using IRA assets, the conversion is likely not a good idea, due to the additional taxes and potential penalties such a strategy would incur. 

  3. Would Potential Tax Savings for Beneficiaries Outweigh Tax Due on Conversion?
    1. If you plan to use your IRA to transfer wealth to your heirs, consider whether you would prefer to have the tax burden fall on you or your beneficiaries. 
    2. A conversion might not make sense if the account is being left to those in lower tax brackets such as young grandchildren, but it might make sense if the money is intended for heirs whose tax bracket is likely to be at least as high as yours.
    3. You may have the flexibility to time a conversion for a period when you are subject to lower taxes, whereas your beneficiaries will have no choice but to withdraw all account assets within ten years of your death.
 
How Else Can I Grow My Roth Funds? 
 
  1. Make non-deductible IRA contributions and conduct a “back-door conversion.” Even if you have a retirement plan through your employer, you can still make non-deductible IRA contributions, up to $6,000 in 2020. These can be made directly to a Roth IRA if you are below the income limitations. If not, you can contribute to a traditional IRA and then convert to a Roth IRA, often referred to as a “back door conversion.” Consult a tax advisor to determine whether this strategy makes sense.

  2. Contribute to the Roth account in your qualified retirement plan. Many qualified retirement plans (such as a 401(k), 403(b) or 457(b) plans) are offering a Roth option within the plan so that you can deposit a portion of your salary deferral contribution to the Roth plan.

  3. Make after-tax contributions if your employer plan allows them. In 2020 you can contribute up to a combined total of $56,000 to your employer plan, so if you contribute the maximum pre-tax amount ($19,000) and your employer does not contribute to your account, you could make an additional $37,000 after-tax contribution. Check with your employer’s plan administrator to see if your plan allows these after-tax contributions.

  4. Consider converting some of the pre-tax or “traditional” portion of your employer plan to the Roth plan. Some of these rules differ from those governing IRA conversions. Consult your advisor for details.
 
What Are My Next Steps?

Once you have addressed your family’s financial and estate planning goals with your attorney and your tax and financial professionals, you will be able to determine if a conversion of your traditional IRA to a Roth IRA, or other Roth strategy, makes sense for you. 

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