As the old saying goes, taxes are one of life’s certainties. But the specifics of what you’ll pay Uncle Sam in any given year are less definite. That’s especially true now, as the Biden administration considers raising taxes on higher wealth individuals. That also means now is a good time to consider a Roth IRA conversion. Let’s look at why this strategy might be a valuable move — and what you should consider before making it.
Refresher: What is a Roth IRA conversion?
A Roth IRA conversion occurs when you move all or some assets from a traditional IRA, simplified employee pension (SEP) IRA or savings incentive match plan for employees (SIMPLE) IRA account, or a qualified retirement plan (QRP) to a Roth IRA account.
Why a Roth IRA conversion is worth considering
The main attraction of a Roth IRA is that it allows for potentially tax-free withdrawals because you make contributions with after-tax money. So, you pay tax today, but not later. That’s unlike a traditional IRA, where you make before-tax contributions that may provide a tax deduction today, but you pay taxes later on withdrawals.
If you’re likely to be in a higher tax bracket in retirement than you’re in now, those tax-free withdrawals may be appealing. Moving some funds from a traditional IRA to a Roth IRA could make sense and could add some tax diversification to your retirement portfolio.
Roth IRAs also don’t have required minimum distributions (RMDs), unlike traditional IRAs. (Note: Roth 401(k)s do have RMDs.) If taking an RMD from a traditional IRA could push you into a higher income tax bracket, then it may be reasonable to shift funds to a Roth. This allows you to take only what you need (or take nothing) while letting the rest of the money continue to grow.
A Roth IRA may also have tax advantages for your heirs. When the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 was enacted, it eliminated the concept of a stretch IRA for most beneficiaries. They must now draw down an inherited IRA within 10 years rather than over a lifetime. Distributions from an inherited traditional IRA would be considered taxable income, but distributions from an inherited Roth IRA would generally be tax-free.
Other key factors to know
Tax implications aren’t all positive. You’ll pay regular income tax on the amount transferred out of the traditional IRA, so you need to make sure you have the resources available to pay those taxes. If you think you’ll be in a lower tax situation in the near future (perhaps your spouse’s income will shrink or you’re retiring) then it may make sense to hold off on a conversion until you’re in a lower tax bracket.
In addition, you should realize that you’ll generally pay penalties if you take converted funds out of the new Roth IRA within five years or before you’re 59-1/2 years old.
Last but not least, be aware that Roth IRA conversions are irreversible — once you move the assets, you can’t convert them back into a traditional IRA.
3 ways to complete a Roth conversion
- Indirect rollovers. With this strategy, also referred to as the 60-day rollover rule, you receive a distribution from your traditional IRA. Then you have 60 days to put those assets into a Roth IRA with no penalty for the withdrawal. You will still pay taxes on the amount transferred if the traditional IRA was funded with pre-tax dollars.
- Direct rollovers. Sometimes known as trustee-to-trustee rollovers, this method involves moving funds directly from a traditional account to a Roth account. A direct rollover can happen between accounts at the same financial institution or between two different banks.
- Backdoor Roth. This strategy is for people whose income surpasses the limit for contributing to a Roth IRA. It allows you to open a traditional IRA using nondeductible funds, then convert that IRA to a Roth. Since you’re moving after-tax dollars, you may only trigger income tax on the earnings from the traditional IRA. However, if you have other traditional IRAs funded with deductible contributions, all your IRA funds will be aggregated together to determine the basis used in calculating the tax due on the conversion. That could result in taxes owed beyond the tax on earnings. Also note that you are limited to the amount of money you can move through a backdoor Roth, whereas there is no limit on other methods of conversion.
How we can help
Whether or not a Roth IRA conversion is right for you depends on multiple factors, including your tax bracket, your income and your financial goals. Hancock Whitney recommends that you speak with your tax advisor, your accountant and a financial professional before making a decision. Your Hancock Whitney team is available to help if you have questions or want to schedule a personal discussion.
The information, views, opinions, and positions expressed by the author(s), presenter(s), and/or presented in the article are those of the author or individual who made the statement and do not necessarily reflect the policies, views, opinions, and positions of Hancock Whitney Bank. Hancock Whitney makes no representations as to the accuracy, completeness, timeliness, suitability, or validity of any information presented.
This information is general in nature and is provided for educational purposes only. Information provided and statements made should not be relied on or interpreted as accounting, financial planning, investment, legal, or tax advice. Hancock Whitney Bank encourages you to consult a professional for advice applicable to your specific situation.
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