Year-end financial planning is important to review and consider last-minute financial planning … [+]
Roth IRA: To Convert or Not Convert?
COVID-19 has brought some interesting wrinkles to the world of financial planning and it is causing people to rethink their tax planning. One of the most pressing questions: does it make sense to convert some traditional Individual Retirement Account funds to a Roth IRA? In other words, this reads like a story headline: Do You Believe Your Taxes Will Be Getting Higher In The Coming Years Due To The Government’s Recent Pandemic Spending?
At our wealth management firm, we have been helping our clients plan for their future retirement needs for decades and we can see how the federal government’s huge spending on pandemic relief might translate into higher taxes down the road. It might be wise to think about paying taxes now, while they are still relatively low, than to risk having to pay more during your retirement years.
Pay Taxes Now Or Pay Taxes Later?
One way to do this is to convert some of your retirement accounts — Traditional IRA, SEP or SIMPLE IRA, maybe an old 401k plan at a previous employer or two — to a Roth IRA. Because you don’t get a tax break for contributing to a Roth IRA, as you do with the other forms of IRA, you must pay income taxes on any funds you convert. But you don’t pay taxes on Roth withdrawals in retirement, including, in most cases, whatever your account has earned. And you are not required to take a Required Minimum Distribution (RMD), starting at age 72, as you are with traditional IRA accounts. Those are huge advantages if you think your tax liability might be higher in retirement than it is now.
Seek Out Professional Advice Before Proceeding
Clearly, the decision to convert or not is a complex one, with big tax ramifications. So it’s best to do this under the careful guidance of your financial advisor or tax pro, who can help take the guesswork out of your deliberations.
If you do decide to convert at least some of your retirement funds to a Roth account, be sure to follow proper procedures to avoid creating a “taxable event.” You must either do a rollover of traditional IRA assets directly into a Roth IRA account, or take a distribution from a traditional account and roll over the amount to a Roth within 60 days. Roth conversions completed after Dec. 31, 2017 cannot be switched back to a traditional account later.
Understanding your income tax liability, now and in the future, is important to your decision-making about a possible Roth conversion. There is no point in generating a tax bill now that would be much larger than if you waited to withdraw the money in retirement. You also might be able to time a series of conversions during years when your tax bracket is lower. You certainly don’t want a single large conversion in any one year to jump you into a higher tax bracket!
Considering A Gift Before Year-End?
You also might consider using your IRA assets to make a charitable deduction. The 2018 changes in the tax law have wiped out charitable deductions for many taxpayers. But if you were to use money from an IRA to make a charitable contribution, the tax deduction for a contribution to a public charity can be up to 60% of a couple’s adjusted gross income (AGI) for cash donations, and up to 30% for donations of securities in an IRA.
Here’s an example of things to consider when pondering whether to convert and how much: If a married couple filing jointly with $115,000 in taxable income converts up to $50,000 to a Roth IRA they could stay within the 22% marginal tax bracket for 2018, which applies to taxable income between $77,401 to $165,000. But converting even a dollar above that limit would push them into the 24% bracket.
And here’s something else to think about. The tax brackets in The Tax Cuts and Jobs Act are scheduled to expire in 2025. If they aren’t extended, they are likely to go higher, especially given the pandemic-relief-induced skyrocketing of the national deficit.
So, What’s The Negative?
But there are some possible disadvantages to a Roth Conversion. For one thing, because a conversion is considered ordinary income, it could bump up the tax rate you could be paying on capital gains and qualified dividends. You also could lose out on a zero cap gains tax and might have to pay more in Social Security taxes.
What’s more, the higher income generated by a Roth conversion could reduce your Social Security payments and force you to pay more for Medicare premiums. And it could strip you of qualifying for a “possible” future stimulus payment if your income goes too high.
Bottom line: tread carefully so your Roth conversion doesn’t turn into a present liability instead of a future tax savings. Work with a financial advisor, consult a tax professional, before year-end to decide on which next step is beneficial to you.