Roth IRA Conversions are a source of interest and confusion for many investors. A Roth IRA conversion involves moving assets already in a Traditional IRA or other retirement account* into a Roth IRA. The growth of assets in a Roth IRA and the distributions from a Roth IRA after age 59 ½ are tax free. Some investors who have assets in a Traditional IRA may benefit from transferring their assets to a Roth IRA in a conversion. Upon completion of this conversion an individual will have a tax liability related to the amount converted. That amount will be taxed at ordinary income rates up to 37%, like your salary. The 10% penalty applicable to early (before age 59 1/2) IRA distributions does not apply to Roth conversions, so they can be completed at any age. Normally contributions to a Roth IRA may be limited if income levels are too high. However, there are no salary restrictions that would prevent someone from completing a Roth conversion. Funds must be available outside the IRA to pay the tax bill for the conversion to be worthwhile financially.
So why do individuals decide to pre-pay their tax obligations to the IRS? Individuals completing a Roth conversion typically fall into two distinct categories.
The first are younger earners who have income growth potential and are able pay for the conversion at a modest tax rate. These individuals often expect that they’ll be in a higher bracket when they pull the funds out and would rather pre-pay the tax now. They’ll also have decades of tax-deferred growth ahead, making that future tax obligation from a dollar standpoint much larger than paying the tax today on the conversion. They may have accumulated money in a Traditional IRA after a rollover of an employer plan that did not have the option to make Roth 401k contributions.
Others who often consider a Roth conversion may be individuals who are retired and are now in a more modest tax bracket. Some wealthy individuals who’ve amassed considerable assets may not have high income or may not be in a high tax bracket due to various deductions or due to the lower taxes on investment gains. These individuals may nevertheless have sufficient wealth so that using funds to pre-pay taxes through a Roth conversion does not have a large impact on their long-term retirement plan. An important motivation in these cases is that their children, who would generally inherit their parents’ traditional IRA assets, may themselves be on a successful career path, be in a high tax state, or both. If these children inherited their parents’ Traditional IRA assets, the children would have to pay 40% or more as they distribute the funds, whereas, after a Roth IRA conversion their parents may be paying only 15% on the assets they convert. Children who inherit assets in a Roth IRA benefit because they do not have to pay taxes on the withdrawal of those assets.
Once the funds are held in the Roth IRA, the individual is not subject to Required Minimum Distributions at age 70 1/2, so they can keep the funds inside of the Roth IRA shell for the rest of their lives without being forced to make distributions or pay taxes, making Roth IRAs great legacy assets. Inherited Roth IRA assets are subject to Required Minimum Distributions in the hands of the heirs with zero tax paid on the distribution over the heirs’ lifetimes.
As a planning-focused firm, we welcome the opportunity to work through these important decisions based on your individual situation. We are uniquely qualified to help you make these decisions based on our experience and being part of a regional accounting firm, Dixon Hughes Goodman LLP.
Please review the attached article from the AICPA that details some of the specific rules surrounding Roth IRA conversions.
*Applies to 401k, 403b, and other “Traditional” retirement plan vehicles if allowable by plan.