Is a Roth conversion right for you?
Cash Flow and Retirement
A main objective of an estate plan is to preserve wealth for your loved ones. There are many strategies to achieve this. If you have a large amount of funds in a traditional IRA — or in an employer plan that you intend to roll over into a traditional IRA — consider whether you might benefit from converting all or a portion of it to a Roth IRA. A conversion can allow you to turn tax-deferred future growth into tax-free growth and take advantage of a Roth IRA’s estate planning benefits.
Wealth preservation benefits
One of the biggest advantages of a Roth IRA is that it’s exempt from minimum distribution requirements, allowing the funds to continue growing tax-free for many years. With a traditional IRA, you’re required to start taking distributions on reaching age 70½ — regardless of whether you need the money — and those distributions are taxable at ordinary income tax rates, not the lower long-term capital gains rates.
With a Roth IRA, you can preserve more wealth for your family by leaving funds in the IRA for as long as possible. After you die, your heirs will be subject to the same distribution requirements that apply to all IRAs inherited by nonspouses. In most cases, they’ll be able to stretch out distributions over their life expectancies and qualified Roth IRA distributions are income-tax-free.
When are withdrawals tax-free?
Distributions of contributions to a Roth IRA can be withdrawn at any time tax-free. Distributions of amounts rolled over to a Roth IRA at least five years prior are similarly tax-free.
When a Roth IRA is at least five years old, qualified distributions of earnings — including distributions after age 59½ and for qualified first-time homebuyer expenses— are tax-free. But that doesn’t mean all Roth IRA distributions escape taxation altogether.
For instance, distributions of earnings before age 59½ that aren’t qualified will be subject to both taxation and an early withdrawal penalty. And distributions that are free of income tax because they’re done on or after attaining age 59½ may still be subject to an early withdrawal penalty in certain circumstances. There are specific ordering rules, so be sure to understand them before taking a distribution.
Timing is a key consideration
Unlike a traditional IRA, which is funded with pretax dollars, a Roth IRA is funded with after-tax dollars. In the case of a conversion, you’re subject to income taxes on the amount you convert as if you’d withdrawn the funds from the traditional IRA and reinvested them in a Roth IRA.
The difference is one of timing: With a Roth IRA you pay the taxes now; with a traditional IRA you pay the taxes when you withdraw the funds. So, which type of IRA creates more wealth?
From an income tax perspective, it depends on the relative tax rates. If your future tax rate turns out to be the same when the funds are withdrawn as it is now, it’s a wash. If you expect your tax rate to be lower in retirement, a traditional IRA likely will produce a greater after-tax return. If you expect your tax rate to go up in retirement, a Roth IRA is generally preferable.
You can reverse a conversion
If the investments in your new Roth IRA lose value after the conversion, you’ll have an adverse tax outcome, because the taxable distribution from the conversion will still be based on the value of the account on the conversion date. In other words, you’ll wind up owing taxes on money you no longer have.
Fortunately, you can avoid this unfavorable outcome by reversing the Roth account back to traditional IRA status. The IRS calls this process “recharacterizing” the account. Once the recharacterization is complete, you’re right back where you started, tax-wise. To reverse a conversion by recharacterizing an account back to traditional IRA status you must submit the required form to your Roth IRA trustee or custodian by October 15 of the year after the conversion takes place.
ROTH IRA and your estate plan
From an estate planning perspective, the Roth IRA is the clear winner.
Traditional IRAs are poor estate planning vehicles because their full value is included in your taxable estate even though your heirs are saddled with a sizable income tax liability on the distributions they receive.
Roth IRAs are also includible in your taxable estate, but the size of your estate is reduced by the amount of income taxes you pay on the conversion, and qualified distributions to your heirs are tax-free. In other words, by paying income tax now on amounts converted into a Roth IRA, you provide a benefit to your heirs by allowing them to receive future distributions tax-free.
Whether this makes economic sense depends on several factors, including whether you’ll have a taxable estate and whether your heirs will take advantage of the ability to defer their distributions over their lifetime.
Before deciding whether to convert your traditional IRA to a Roth IRA, be sure to consider all of the income and estate tax implications — including the tax consequences of the conversion itself. Your estate planning advisor can analyze your current situation and help you decide if converting a traditional IRA to a Roth IRA will be beneficial.
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