If you are like most hard-working Americans, you have been building your retirement nest egg by contributing to either a traditional IRA, some form of self-employed tax-deferred account or to your employer’s retirement plan. These plans provide a tax break on your current contributions in exchange for being taxed on your future distributions in retirement.
You owe it to yourself, nevertheless, to look into the potential financial benefits of including a Roth IRA within your retirement portfolio. Although you cannot deduct your current Roth IRA plan contributions, your investment earnings grow tax-free and you pay no income tax on future withdrawals as long as you have participated in the plan for at least five years and are at least age 59 ½ (or are disabled, deceased or make a qualified first-time home purchase).
Another advantage of Roth IRA’s is that you do not need to start taking required minimum distributions (RMD’s) at age 70 ½, as is the case for virtually all other tax-sheltered retirement plans. This allows your Roth funds to continue to grow tax-free while you make the mandatory draw downs on your other tax-deferred retirement accounts.
While Roth IRA’s are subject to contribution limitations and income phase-outs, there are no such restrictions on conversions. Read on to see if a Roth IRA conversion may be right for you.
- Your IRA contributions are limited and may be phased out
Total annual contributions to a traditional or Roth IRA are limited to a combined $5,500 in 2015 ($6,500 if 50 or older), but contributions are phased out based on modified adjusted gross income (your AGI plus certain deductions). For 2015, the Roth IRA phase-out range begins for joint incomes of $183,000 ($116,000 for singles and heads of households) and completely phases out at $193,000 ($131,000 for singles and heads of households). If you earn too much to open a Roth IRA, you can still open a nondeductible IRA and then convert it to a Roth.
- Conversion Rules
There are no AGI constraints on Roth conversions. In the year of conversion, you simply pay income taxes on the amount converted in exchange for tax-free distributions in retirement. If you are not eligible to contribute to a Roth IRA and your employer’s plan does not allow you to make Roth-designated contributions, then a conversion can provide a means by which take advantage of a Roth IRA’s potential benefits.
A number of tax-deferred retirement plans are eligible for Roth IRA conversions including:
- Traditional IRAs
- Self-employed plans such as a Savings Incentive Match Plan (SIMPLE) IRA [after two years] or a Simplified Employee Pension (SEP) IRA
- Federal government 457(b) plans
- School and tax-exempt organization employee 403(b) plans; and
- A designated Roth account within a 401(k), 403(b) or 457(b) plan
Except in the case of a designated Roth account, all income is taxable in the year of conversion.
- Key Considerations
To determine whether a Roth conversion can benefit you, consider these factors:
- Your current and anticipated future tax brackets – If you think your tax bracket during your retirement years will be the same or higher then it is today, then a conversion might make sense; you would incur today’s tax liability in exchange for future tax-free withdrawals in retirement
- Your time horizon – The farther away you are from your retirement years, the more sense a conversion makes. Time is on your side and it allows you to recoup the lost opportunity cost of the funds you used to pay the current tax, regardless of their source. Generally, the younger you are, the more favorable a Roth conversion would be
- Source of the funds used to pay the tax – If you pay the tax from your IRA (or other tax-deferred retirement plans), you lose the potential benefit of tax-free growth on that amount, which defeats the purpose of converting. The portion of the IRA that is used to pay the income taxes is not converted but is still subject to income taxes as well as the 10% early withdrawal penalty if you are under age 59 ½.Say you are age 35, in the 25% tax bracket and convert $10,000 of a traditional IRA to a Roth, but use a portion of the conversion to pay the taxes. As a result, you would owe $2,500 of income tax, plus a $250 early withdrawal penalty while only $7,250 actually makes it into your Roth. A conversion is usually more feasible if you have the funds available outside of the IRA account to pay the taxes. The general rule-of-thumb is to pay taxes from taxable funds.
- Use a step approach – There is no requirement that you convert all of your IRA accounts in one year. With proper planning, you can determine the precise amount to convert each year to prevent your income from reaching the next tax bracket as well as allowing for some financial headroom since all of the taxes would not be due at one time. In effect, you would pay the conversion tax on an installment basis each year while minimizing the tax effect
- Potential maximization of value to heirs – Although an older taxpayer may not benefit from a conversion at face value, it may provide a good estate-planning tool in that it represents untapped investment funds (no RMD’s). D espite the fact that its value is included in your gross estate, the account could grow larger than would a traditional IRA, thereby leaving more to your heirs to withdraw tax-free over their lifetimes. Moreover, the income tax paid at the time of conversion will reduce your gross estate, thereby having the effect of a tax-free gift by prepaying income tax on behalf of your future beneficiaries
- Traditional IRA aggregation rule – If you have made nondeductible contributions to your traditional IRA in past years (reported on IRS Form 8606), you cannot select which portion of the traditional IRA account is converted to a Roth. The IRS considers all traditional IRA accounts as one when it comes to distributions, including Roth conversions. Traditional IRA balances are aggregated so that the amount converted consists of a prorated portion of taxable (deductible contributions) and nontaxable (nondeductible contributions) funds
- Converting nondeductible IRA contributions to a Roth– Since 2010, high earners who are not eligible to make Roth contributions can make nondeductible contributions to a traditional IRA and then convert those amounts to a Roth on an annual basis (be aware that Congress may address this tax loophole in the future)
- Recharacterization –You can recharacterize, or reverse a contribution or conversion any time up to the income-tax-filing deadline, including extensions, for the tax year of the conversion. For example, if you convert in 2015, you can recharacterize as late as October 15, 2016. If you recharacterize a Roth conversion and later change your mind, you cannot reconvert back to a Roth until the following year (for example, 2015 or later if you converted in 2014), and you must wait 31 days after the recharacterization (no reconversion is allowed within 30 days of the recharacterization). However, there is no recharacterization provision for 401(k) conversions
Under the right set of circumstances, a Roth IRA conversion can provide significant benefits, but each situation is unique. We are available to discuss your particular situation and assist you in the decision-making process.
For more information on a Roth IRA conversion or another area of accounting, please contact Victor C. Belgiorno at 516-861-3704 or or Bob Jahelka at 516-861-3707 or .