By Heidi Huiskamp, Founder and CEO of Huiskamp Collins Investments, LLC
There’s a lot to like about Roth IRAs. Contributions to them are after-tax and the growth over time will never be taxed when you take distributions out after reaching 59-1/2 years old. That’s a really valuable perk as your tax-deferred retirement plan at work or the Traditional IRA you’ve contributed to so you can take a tax deduction will be fully taxed, including growth, when you start taking distributions from it. In 2021 and 2022, investors’ adjusted gross income (AGI) must be under a certain threshold to invest in a Roth IRA and are limited to a $6,000 contribution if they are under 50 years of age and $7,000 if they are over that age limit. I have many senior clients who don’t need distributions from their tax-deferred retirement accounts when they are forced by the IRS to start taking distributions and paying taxes on them at age 72. Wouldn’t it be nice to never have lifetime Required Minimum Distributions (RMDs) and set yourself and your heirs up to receive tax-free distributions if you expect tax rates to be higher in the future? A Roth Conversion just might be your solution.
Roth conversions are a snap, but they take careful planning with both your financial advisor and your tax professional. There’s a lot to like about making tax-deferred money tax-free, but the downside is that you will be on the hook to pay taxes now rather than in the future. Best case scenario is if you have savings or cash flow to pay the taxes owed on the funds you convert. Taking extra money from your tax-deferred account to pay the taxes is not a good option. It sets back your retirement savings and you could risk a 10 percent penalty if you take the funds out of the tax-deferred account if you are younger than 59-1/2. If you have the spare cash, the best strategy is converting your tax-deferred account over a number of years to achieve the lowest possible tax-deferred balance after 72 or whatever age you might be forced to take RMDs by converting enough to achieve that result without boosting you into the next highest tax bracket.
There are a few things to know about conversions. There are no minimum or maximum income limits or minimum or maximum age at which you can implement a Roth conversion. Additionally, there are no filing status restrictions. A few types of accounts are ineligible for Roth conversions. Non-governmental 457 retirement plans (some hospitals and the like) cannot be converted. SIMPLE IRAs from small employers can’t be converted in the first two years that an account owner has them. And lastly, please be careful about inherited Traditional IRAs. Inherited IRAs of this type can’t be converted, but if you are named as the beneficiary of a company 401k, you can pay the taxes on those assets and convert the funds to a Roth IRA before it becomes an inherited IRA.
Some circumstances are ripe for Roth conversions. If you are a business owner and have a net operating loss from your business that will impact your bottom-line adjusted gross income for the year, a Roth conversion might make a lot of sense. The same goes for a particular year when your income is lower than average and you have a lot of personal deductions that will exceed the standard deduction. Roth IRAs are more valuable the longer they have to grow and increase in value, so if you are a young investor and have the extra cash, converting earlier rather than later will be in your best interest. Many investors plan on moving to lower tax states in retirement, but what if your kids and grandkids live in a higher tax state like California or New York? Being close to family may be the “deal clincher” for you and having a pot of tax-free money may make sense if this sounds like you. Another possibility is those who expect large inheritances later in life that may throw off income that might put you in a higher tax bracket. Having access to tax-free funds rather than paying “full-freight” on RMDs might make sense for you. Lastly, couples that anticipate one spouse dying first may institute Roth conversions of tax-deferred accounts to combat the “widow’s penalty.” Many times, a widow/widower will pay more in taxes than the couple paid without a big jump in income just because she/he is now classified as a single tax filer rather than the often lower tax rates for a married couple filing jointly. Reducing RMDs with planned Roth conversions may really impact the amount that the surviving spouse must pay in annual taxes.
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Securities offered through J.W. Cole Financial, Inc. (JWC). Member FINRA/SIPC. Advisory services offered through J.W. Cole Advisors, Inc. (JWCA). Huiskamp Collins Investments. LLC and JWC/JWCA are unaffiliated entities.