If you’re familiar with Roth IRAs in the realm of retirement planning, then you’re probably aware of their tax benefits: tax-free withdrawals from your retirement account being the biggest one. The money you take out of your employer-sponsored Roth IRA will be tax-free if you have had a Roth IRA for at least five years and your age 59½ or older, disabled or taking a first-time homebuyer distribution. Depending on your age when you start a Roth IRA, and the performance of your investments, this could mean a significant amount of tax-free income in retirement.
At the current contribution limit, it may be difficult for some investors to accumulate enough assets in their Roth IRA for it to provide a meaningful component of their retirement income or to purchase the types of investments they’d like to have in a self-directed Roth IRA. One way to boost your Roth IRA’s tax-free growth potential is to move your other retirement savings into your Roth IRA. Because Roth IRAs hold after-tax assets, any pre-tax retirement savings that you convert will be taxable to you in the year you move the assets to a Roth IRA.
Assets Eligible for a Conversion
Examples of the types of retirement savings accounts you currently have that could be converted to Roth savings include your:
- Traditional IRA, SEP IRA, and SIMPLE IRA (after a 2-year waiting period), and
- 401(k) plan, profit sharing plan, 403(b) plan, and governmental 457(b) plan, when you are eligible to take a distribution from your employer plan.
Note: you may not convert required minimum distributions (RMDs) or other amounts that are not eligible for rollover.
Conversion Rules
The amount distributed from the sending account, including any withholding, must be claimed as taxable income in the year of conversion (except any portion representing non-deductible or after-tax contributions). Even if you are under age 59½, the 10% early distribution tax will not apply at the time the dollars are distributed from the sending account.
Once your Roth IRA conversion is complete, the converted amount will be treated as a Roth IRA going forward. Just like the amounts you contribute as annual contributions, you may withdraw your conversion money tax-free at any time. But if you convert taxable assets to a Roth IRA before you reach age 59½, and you make withdrawals on those converted assets within five years of the conversion, IRS rules state that you will owe the 10% early distribution tax that you previously avoided. However, the early withdrawal penalty will be waived if you meet an exception (such as being over age 59½, disabled, or having qualified higher education expenses). A separate five-year period applies for each conversion.
If you do not need to use your Roth IRA assets as a source of income in retirement, you can continue to let your Roth IRA investments accrue earnings tax-free and can even make additional Roth contributions if you meet the eligibility requirements (earned income within certain limits). You will not be forced to take retirement distributions because Roth IRAs are not subject to the age 70½ RMD rules.
Candidates for Roth Conversions
The Roth conversion option allows you to decide when you want to pay conversion taxes on your retirement assets. Many investors build retirement income strategies that include both pre-tax and after-tax assets to diversify the tax nature of their retirement income. Roth IRA assets may also be appealing to individuals who:
- Believe their investments will significantly appreciate in value
- Have many years to accumulate tax-free earnings
- Expect to be taxed at a higher tax rate in the future
- Are highly compensated employees who have not been able to contribute to a Roth IRA because of the earned income restrictions
- Want to provide tax-free assets to their heirs
Considerations
Individuals who are considering converting a sizeable amount of pre-tax assets to a Roth IRA should consult with a tax advisor to discuss all the potential tax consequences of a conversion:
- A Roth conversion will increase your gross income (taxable income) for the year. The increased income may bump you into a higher tax bracket unless you spread the conversion over multiple years. Moving to a different income tax bracket can have implications on your federal income taxes due.
- While conversion amounts are not taxed as investment income, the increase in taxable income could potentially cause you to become subject to the 3.8% Medicare tax on your net investment income.
- You will want to have other assets to pay the tax liability for the conversion, so you don’t have to draw from your taxable retirement savings to pay the tax bill.
If you’re thinking about converting assets to a self-directed Roth IRA account, make sure you understand the benefits and the tax year impact before you complete the conversion. Speak to your financial advisor to learn more about IRA funds for estate planning, and contact our team at Mainstar Trust for help on setting up an account for your Roth IRA contributions today.