Roth ConversionsMar 09, 2020
A Roth conversion means taking your Traditional IRA, or some portion of it, and turning it into a Roth IRA. Whatever dollars are converted become taxable to you right then and there.
Who should consider a Roth conversion?
In a previous post we went into the Roth IRA – how it works, and how to make it work for you. In this blog post we delve into the topic of Roth conversions. Before launching in, though, we’ll begin with a brief review of IRS rules on getting money into your Roth IRA.
Your contribution limits are $6000 year or $7000 if age 50 or older (2020). You must have earned income to contribute. This is W-2 income or income from a trade or business. In other words, investment earnings and Social Security income do not count. Additionally, the IRS begins to phase out a taxpayer's ability to make a Roth contribution if his adjusted gross income, as a single taxpayer, exceeds $124,000, or $196,000 for married taxpayers filing jointly (2020).
What are the Benefits?
There are two principal benefits. Withdrawals in retirement from a Roth IRA are not taxable. Would you rather have a $500,000 IRA from which all withdrawals are taxable, or a $500,000 Roth IRA from which all distributions are free of taxation? The latter of course.
An additional benefit from the Roth is that there is no required minimum distribution, as there is with the Traditional IRA at age 72.
I’m Over the Income Phaseout!
You still have options. You can convert your traditional IRA into a Roth without limit. Conversion means that you set up a separate Roth IRA, and then transfer funds from the traditional IRA into the Roth. The dollars transferred are fully taxable, at ordinary tax rates. The trade off, then, is a tax hit now, in favor of a tax-free stream of income in retirement that could last for years and years.
The tax issue here should make some kind of sense in that you didn't get taxed on your contributions to your Traditional IRA (they were made before taxation) so they get taxed now. But all the earnings up to the conversion point also get taxed now.
Consider a Partial Conversion
You can, and maybe should, convert a little at a time, to manage the taxation. Here’s an example: We have one client who unfortunately become disabled. His disability income insurance payments are not taxable, so he has essentially no taxable income. We recommended that he gradually convert his traditional IRA to a Roth, a little bit at a time over several years, enough to use up the standard deduction. The result is that when his income from disability insurance ceases at age 65, he’ll then have a non-taxable source of income from his Roth to last him the rest of his life. This is good planning.
5 Year Rules
Once you’ve converted, there are some tax caveats. Converted amounts must remain in the Roth for 5 years before withdrawal. If converted amounts are withdrawn before 5 years are up, they become subject to a 10% tax penalty. Any earnings withdrawn before 59 ½ on the converted amount get taxed as well, with a 10% penalty.
Re-Characterizing a Conversion is No Longer Possible
It used to be that if you did a Roth conversion, you had a limited ability to undo it. Say you converted $100,000. The market dropped, and now it is only worth $80,000. You could undo the conversion, re-file taxes for the year of the conversion, and receive a refund. Then you'd be taxed on the $80,000 that gets re characterized in the next tax year.
This is no longer possible; the Re-characterization were eliminated in the 2017 Tax Cuts and Jobs Act.
Look for Opportunities
Roth IRAs are such a great deal tax-wise that we like to see our clients look for conversion opportunities. Here are a few:
- You've had a period of unemployment, so your income is lower. Consider a partial conversion.
- You've made large charitable contributions in one tax year. Consider offsetting the charitable deduction with a partial Roth conversion.
- A spouse stops working, so your income will be lower this year. Consider a partial Roth conversion.
- A child is born to you. Congratulations! That means a $2000 tax credit (2020). Consider converting an amount that would generate no more than $2000 in new tax.
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