JUNE 2019 –
In this blog post, we review the potential benefits of Roth IRA conversions, starting with a refresher on Roth IRAs and then exploring a few Roth conversion strategies.
A Quick Refresher on Roth IRAs
The Roth IRA was established by the Taxpayer Relief Act of 1997. It is similar to the traditional IRA in many ways, but with some notable differences.
Generally, Roth IRAs allow individuals to contribute non-tax-deductible (post-tax) dollars to an account that will shelter the assets from taxation until the money is withdrawn. Upon withdrawal, qualified distributions from a Roth are not taxable, provided that certain requirements have been met, such as having held the account for five years and having attained age 59 ½ (or death, disability, or for a first home purchase). These rules are outlined in detail on the IRS website and in IRS publication 590.
Money that was contributed directly to a Roth IRA can be withdrawn at any time, for any reason, without tax or penalties. The distribution ordering rules for Roth accounts dictate that upon distribution, contributions come out first before amounts that resulted from earnings or conversions.
Example: Martha is 35 years old and has contributed $10,000 to her Roth IRA account over the past few years. The account balance has grown to $16,000 due to gains in her investments within the account. Martha can withdraw her $10,000 in contributions from her Roth IRA any time without tax or penalties.
Contribution limits for a year are identical to traditional IRA limits: $6,000 per individual, or $7,000 if you are age 50 or older. This amount is the combined annual maximum between traditional IRAs and Roth IRAs.
Example: Eric is 48 years old and has already contributed $6,000 to his traditional IRA this year. He cannot make any contributions to a Roth IRA.
Example: Kim is 68 years old and has already contributed $3,000 to her traditional IRA this year. She can potentially make an additional $4,000 in contributions to a Roth IRA.
Roth IRA Advantages: Diversify Your ‘Tax Portfolio’
Money in a Roth IRA is not subject to required minimum distributions after age 70 ½, thus allowing the account owner to defer distributions for a longer period. There is no income tax due on distributions, providing that the above-noted requirements have been satisfied. Financial planners often discuss the importance of a well-diversified investment portfolio. A Roth IRA allows retirees to diversify their portfolio of strategies to optimize their tax situation.
Roth Conversion Basics
A Roth conversion involves the movement of money from a traditional IRA to a Roth IRA. Income tax is generally due on amounts that represent conversions of previously deductible (pre-tax) dollars coming from the traditional IRA.
Example: John has $100,000 in total traditional IRA assets that all came from sources that were previously tax deductible, plus investment gains on those amounts. Any amount that John converts from his traditional IRA to a Roth IRA will be taxable.
Example: Melissa has $100,000 in total traditional IRA assets, of which $25,000 came from non-deductible contributions that Melissa made over the years. Each dollar that Melissa converts to a Roth IRA will result in $0.75 of taxable income.
If all an individual’s traditional IRA assets came from non-deductible sources, and there were no earnings on those contributions, the amounts converted to a Roth IRA would have no income tax liability.
It is worth mentioning that individuals cannot ‘cherry pick’ which IRA assets will be converted.
Example: Tom has $100,000 in total traditional IRA assets. One account is worth $95,000 and is made up entirely of pre-tax contributions and earnings on those contributions. Another account is worth $5,000 and consists entirely of post-tax contributions that were never deducted. Tom cannot simply isolate the $5,000 account for potential Roth IRA conversion to avoid taxation. If the $5,000 account is converted, $4,750 of the amount converted will be taxable given that only 5% of Tom’s total traditional IRA assets were non-deductible.
Strategies for High-Income Savers: Annual Backdoor Roth Conversions
Individuals and married couples that have relatively high income levels may not be able to contribute directly to a Roth IRA, but they do have the ability to convert to a Roth IRA, regardless of income. For example, a married couple in 2019 cannot contribute to a Roth IRA if their modified adjusted gross income (AGI) is over $203,000. These individuals may still be eligible to make non-deductible contributions to a traditional IRA and then immediately convert those funds to a Roth IRA.
This strategy works particularly well for those who do not have any pre-tax money in their traditional IRA accounts. Note that money held in a 401(k) plan is not considered money in an IRA account when considering the tax consequences of a Roth conversion. Many 401(k) plans allow participants to process ‘reverse rollover’ transactions, allowing them to move money from an IRA to the 401(k) plan. This tool creates an opportunity to remove pre-tax assets from an IRA prior to processing a conversion, thus reducing or eliminating income tax liabilities on Roth conversions.
Once IRA accounts are void of any pre-tax money, an individual can make an annual contribution to a traditional IRA without deducting it, and then immediately convert this amount to a Roth IRA, while having little or no income tax liability on the transaction. This strategy can be repeated each year going forward unless there are changes to the tax system in the future that eliminate this opportunity.
Example: Tom, from our previous example, rolls his $95,000 traditional IRA account to his employer’s 401(k) plan, leaving him with just the $5,000 non-deductible traditional IRA account. He can now convert this account to a Roth IRA with no tax due on the conversion.
Strategies for Retirees: Conversions in Low Income Years
Individuals who retire in their 60s may have some attractive Roth conversion opportunities as well. This decade brings several interesting tax strategies into play for retirees, especially those who have elected to defer receiving their Social Security benefits. For example, a 65-year old retiree who has saved money toward retirement outside of IRA or employer-sponsored retirement accounts may be able to enjoy some years of little-to-no taxable income. These may be good years to convert modest amounts of traditional pre-tax IRA money to Roth IRA accounts while levels of taxable income are low.
This opportunity will likely go away once that individual is in their 70s, given that they can no longer delay Social Security benefits and will need to take taxable required minimum distributions from their retirement accounts following age 70 ½.
We encourage you to have a conversation with your tax advisor about the use of Roth conversions in your overall financial plan. Bigelow does not provide tax advice and the above examples are for general illustrative purposes.