As many individuals become more concerned about the impact of taxes in retirement, Roth IRAs present a unique retirement vehicle to consider. Qualified distributions from a Roth IRA are income tax-free, and there are no Required Minimum Distributions (RMDs) during the Roth IRA owner’s lifetime.  

Investors should consider how to diversify their tax liability by spreading assets among taxable, tax-deferred and tax-free accounts. Often, investors hold a disproportionate percentage of their assets in tax-deferred accounts, such as Traditional IRAs and 401(k)s, with little or no assets in tax-free retirement vehicles, like a Roth IRA. Tax diversity allows taxpayers to control their tax brackets during retirement.

A conversion is a taxable transfer of funds from an eligible retirement account, such as a Traditional IRA or 401(k), to a Roth IRA. When you convert your eligible retirement account to a Roth IRA, you will pay income tax on the taxable amount converted in exchange for tax-free growth and distributions in the future. If you can pay the tax due on conversion from a taxable account, more wealth is transferred into the tax-free account.

The Ideal Candidates for Conversion:

  • Don’t expect a significant decline in their marginal tax rates in retirement.
  • Can afford to pay the income tax on conversion from other assets. 
  • Intend to transfer their Roth IRA at death to beneficiaries who will “stretch” it.
  • Can afford to use other assets for living expenses at retirement and allow the Roth IRA to grow (or begin taking distributions much later in retirement).
  • Will have lower taxable income in the year of conversion.

Factors Against Conversion:

  • Expects to be in a lower tax bracket during retirement.
  • Lives in a state that does not provide creditor protection to Roth IRAs (traditional and Roth IRAs are protected under Ohio Law).
  • Will pay the tax from the IRA funds (and even worse, the taxpayer is under 59½.)
    • Use of retirement accounts to pay taxes could result in a 10% penalty tax if the conversion is completed prior to age 59½.
  • Have a child in college whose financial aid would be negatively impacted by conversion.

The following chart can help guide the decision to convert or not convert:

The Tax Cuts and Jobs Act (TCJA) makes Roth IRAs even more attractive today for some taxpayers. Today’s federal income tax rates might be the lowest we will see in our lifetime. A Roth conversion may provide insurance against future tax rate increases that may be inevitable. The cost of this “tax insurance” is lower than ever with today’s lower tax rates.

There are many factors to consider, and we recommend you consult with your tax adviser and financial planner for guidance and analysis before making a conversion. Under TCJA, Roth conversions cannot be undone. Congress repealed Roth recharacterizations, which previously enabled Roth conversions to be reversed. Consequently, Roth conversions will require more advice and require more careful analysis before making a decision.

Sequoia can help you determine if there is a reasonable expectation that the benefits of “pre-paying” taxes via a Roth IRA conversion make sense in your overall financial and estate plan. The financial analysis should consider the multi-generational benefits and employ a qualitative approach by considering the many factors that weigh the advantages and disadvantages of converting a tax-deferred qualified plan to a Roth IRA.

Contact Michael Cymbal, CFP®, CPA, to learn more about this topic.
330.255.2125 | mcymbal@sequoia-financial.com

 

This material is for informational purposes only and is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product.  The opinions expressed do not necessarily reflect those of author and are subject to change without notice.  Diversification cannot assure profit or guarantee against loss. There is no guarantee that any investment will achieve its objectives, generate positive returns, or avoid losses. Sequoia Financial Advisors, LLC makes no representations or warranties with respect to the accuracy, reliability, or utility of information obtained from third-parties. Certain assumptions may have been made by these sources in compiling such information, and changes to assumptions may have material impact on the information presented in these materials.  Investment advisory services offered through Sequoia Financial Advisors, LLC, an SEC Registered Investment Advisor. Registration as an investment advisor does not imply a certain level of skill or training.