Roth IRA conversions can deliver some lucrative hidden benefits
You might ask how does the Roth IRA conversions deliver some lucrative hidden benefits? Lets first go over the basics.
Unlike traditional IRAs whose distributions are taxed, their Roth counterparts generally come with tax-free distributions once you reach age 59½. They also come with no required minimum distributions — annual amounts you must take starting at age 70½ — during your lifetime.
However, contributions aren’t tax-deductible the way they are with traditional IRAs or 401(k) plans. That means if you move pre-tax money from one of those accounts to a Roth IRA, you must pay taxes on the amount moved — and have a plan for paying the taxes due.
Right now, though, federal taxes are relatively low, which would mean paying less than you might down the road if you were to wait to do a Roth conversion but Federal taxes are the fuel to keep the government running so it’s more likely that taxes will rise in the future, not go down.
With a Roth IRA there are contribution and income limits that apply to direct contributions made to a Roth IRA, those restrictions don’t exist for assets transferred from other qualified retirement accounts.
At the same time, however, there may be reasons not to do a conversion or to limit how much you convert in one year. Some of the rules can get confusing and it should also fit into the context of your overall financial plan. It’s wise to get professional guidance to ensure the move makes sense for your situation.
Below are some of the situations where a Roth conversion might be right for you.
The widow penalty.
Even for retired couples with more modest income, a Roth rollover can make sense if it’s anticipated that one spouse will outlive the other.
The reason is that household income may not drop all that much after the death of one spouse. When that’s the case, being taxed as a single filer generates more in taxes than filing jointly as a married couple.
For example, income of $60,000 puts a married couple in the 12% tax bracket. A single filer with that income would be in the 22% bracket. Additionally, the standard deduction for single filers is half that for married couples: $12,200 vs. $24,400 in 2019.
So, the idea is that if the couple did a Roth conversion, the surviving spouse could have some tax-free income instead of paying at a higher rate.
That possible change in filing status is important for the decision to do the conversion or not.
Retiring early
While regular IRAs and 401(k) accounts generally come with a 10% penalty if you withdraw money before age 59½, the rules are slightly different for Roth IRAs.
Direct contributions — which, again, are after-tax — can be withdrawn at any time penalty-free. The earnings, though, generally must remain untouched to avoid the penalty (and taxes).
For money that’s converted to a Roth IRA, you can avoid the penalty as long as you leave it alone for five years. As with direct contributions, however, the earnings remain off-limits until age 59½ or you’ll pay the 10% penalty, as well as taxes.
With federal tax rates relatively low, now might be a good time to convert money and pay taxes on it at current levels rather than chance that rates will go up down the road.
Assets converted from another qualified retirement account are not subject to the contribution and income limits that come with direct contributions.
Some less obvious situations when such a move might make sense include plans for an early retirement or anticipation of the so-called widow penalty, along with small-business owners looking to better capitalize on the 20% pass-through deduction.
For some savers, the appeal of moving assets to a Roth individual retirement account often stems from the tax-free income it will deliver in their golden years but it is not for everyone.
While you’re subject to the same federal tax rate regardless of where you live, the same can’t be said for state taxes.
Some retirees in search of lower taxes head to states with no income tax, such as Florida. Regardless of the reason, if your new home would be in a state with a higher tax rate than you have now, converting money to a Roth IRA from a 401(k) or traditional IRA would mean being able to avoid that new, higher rate altogether when you take money out. On the other hand, if you’re heading to a low- or no-tax state and are considering a Roth conversion, it might make sense to wait until after the move.
Whatever you decide to do it’s wise to get professional guidance to ensure the move makes sense for your situation.
NOTE:
The opinions stated here are my own and do not constitute financial advice in any way whatsoever. Nothing published on my website constitutes an investment recommendation, nor should any data or content published be relied upon for any investment activities. I strongly recommend that you perform your own independent research and/or speak with a qualified professional before making any financial decisions. My website does not warrant or make any representations concerning the accuracy, likely results, or reliability of the materials on my website or any sites linked on my website.
