Now might be a good time for a Roth IRA conversion
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Roth IRAs are similar to traditional IRAs except that Roth contributions are “after-tax,” which means you pay taxes on your contribution upfront. Consequently, withdrawals from Roth IRAs are tax-free, meaning that your investment earnings and growth are never taxed. Traditional IRA contributions are not taxed upfront, but are instead taxed when you take a distribution from the account. Depending on your situation, a Roth may create significant value for you and your heirs.
Many people are well aware of two key advantages of a Roth IRA: the ability to withdraw money tax-free (which appeals to anyone who wants to minimize their tax bite in retirement) and the ability for wealthier taxpayers to maximize assets and minimize taxes for their heirs. Unfortunately, high earners often assume they are ineligible for a Roth IRA. This is not necessarily true. Even though you might not be eligible to contribute directly to a Roth IRA, you might be able to convert a traditional pre-tax IRA into a Roth IRA.
Generally, only taxpayers with income below certain levels may contribute to a Roth IRA. In 2020, individuals with income less than $139,000 and married couples filing jointly with income of $206,000 or less are eligible.¹
However, all taxpayers, regardless of income, can convert some or all of their traditional pre-tax IRAs to a Roth IRA. During a “Roth conversion,” you elect to pay income taxes now on a portion of your pre-tax accounts. These amounts are then transferred into a Roth IRA account, where they are treated as a regular after-tax Roth IRA. Additionally, during a Roth conversion, income taxes are only calculated on the pre-tax conversion amount. Non-deductible “basis” is not included in the tax calculation, and there are no additional penalties for those younger than 59½.
This strategy may be particularly valuable during periods of market stress. In difficult economic periods, such as a bear market, the value of your pre-tax traditional IRA may have declined. By converting a portion of this account to a Roth, you’ll pay taxes on a smaller market value. As your portfolio recovers, the Roth IRA and all future growth will be forever tax-free.
Advantages of a Roth IRA:
When money is distributed from a Roth it is entirely tax-free including the earnings.
There are no annual required distributions from a Roth IRA (as there are for a traditional IRA).
A Roth IRA is a tax-efficient way to transfer wealth to beneficiaries upon the account owner’s death. A spouse inheriting their partner’s Roth is not required to take mandatory distributions, while non-spouse beneficiaries must take distributions within the first ten years after the original owner's death. In either case, all distributions are withdrawn tax free.
Now might be a good time for a Roth
For many of our clients, now is the perfect time to discuss whether converting their traditional IRA to a Roth makes sense based on their unique circumstances. We can discuss eligibility requirements, the pros and cons of a conversion, and the potential benefits of a Roth IRA for intergenerational wealth transfer.
As always, please reach out to us if we can assist with your understanding of whether a Roth might make sense for you when viewed as part of your overall long-term financial plan.