Using a Roth IRA Conversion to Lower Your Tax Liability in Retirement
Many workers use qualified retirement accounts, such as employer-offered 401(k) or 403(b) plans and individually opened traditional IRAs, to save for retirement.
A major attraction of these retirement vehicles is that taxes on the earnings are deferred. That can be beneficial while you are working, but on-going deferrals over the long-term can also lead to large tax bills once you retire.
The distributions you take from these accounts to live on in retirement are taxed at ordinary tax rates, not the generally lower capital gains tax rates.
There is, however, a way to reduce the potential tax bite of tax-deferred retirement accounts. Go Roth.
Why choose a Roth account
The Roth IRA was created in 1997 and named after its chief legislative sponsor, the late U.S. Sen. William Roth of Delaware. It offers a way for workers to save retirement money that will be tax-free when withdrawn.
Contributions to a traditional IRA or tax-deferred defined contribution plan are not taxed when made, so you must pay the Internal Revenue Service upon withdrawal. The IRS ensures this payment by requiring specific withdrawals, known as required minimum distributions, which begin when you turn 70½.
Roth IRAs use the opposite approach. The money you put into the account is already taxed, but withdrawals of your contributions and earnings are tax-free once you reach age 59½.
In addition, you always can access at any age your own Roth IRA contributions tax- and penalty-free. Plus, the Roth IRA does not have a mandatory withdrawal requirement allowing for compounding tax-free growth during retirement years.
Some companies also offer Roth 401(k) options that operate much the same as, but not identical to, the IRA version with the major benefit of the Roth 401(k) being that there are no income limits on your ability to contribute like there are with Roth IRAs.
Working around Roth limitations
Despite the obvious no-tax appeal, there are some Roth IRA limits. There are, however, ways to work around these downsides.
As previously mentioned, the major drawback to a Roth IRA is the earnings limit. If you make more than a specific amount, which is adjusted annually for inflation, you cannot contribute to Roth IRA.
However, there is no income restriction on converting traditional IRA money to a Roth account. This means that you can make a non-deductible contribution to a traditional IRA and immediately convert it to a Roth IRA in the same year.
Once the traditional-to-Roth conversion is complete and taxes paid, you have eliminated IRA tax concerns in retirement on the converted amount.
Roth IRA conversions can also be effective if you wish to leave a generous inheritance to your children. With a Roth account, you minimize your future beneficiaries’ tax liability.
Some traditional IRA owners, particularly those who have socked away a large amount in the tax-deferred account, are hesitant to convert. The reason? You must pay tax on any tax-deferred amounts when you move them to a Roth IRA.
Converting a large traditional IRA, therefore, could mean a major federal income tax bill.
However, you do NOT have to convert the full value of a traditional IRA in any one year. The most effective strategy is to review your taxable income annually and convert incrementally up to the peak of your tax bracket in any given year.
Roth second thoughts
What if you converted a traditional IRA to a Roth, paid tax on that amount and then decide you shouldn’t have? You are allowed a do-over.
You can reverse a Roth conversion — the process is known as a recharacterization — up to Oct. 15 of the year following the conversion. This option is available regardless of whether you file an extension.
For example, if you convert a portion or all of a traditional IRA on Dec. 31, 2017, you have until Oct. 15, 2018, to recharacterize.
Note, however, there are limits on multiple recharacterizations. Also, if you filed your tax return before recharacterization, you must file an amended return reducing the intended conversion amount from your income.
Your wealth management advisor can help you determine whether converting a traditional IRA to a Roth account is a wise financial and tax move for your personal and your family’s circumstances.
If so, your advisor can help you sort through the conversion details and process to ensure that both you and the IRS are happy with your new, tax-saving Roth individual retirement arrangement.