For Many (But Not All) Employees, Now is a Good Time to Consider a Roth IRA Conversion
Edward A. Zurndorfer–
If there is any unseen benefit coming out of this year’s down stock market, it is the fact that now is an opportune time to consider converting a traditional IRA invested in stocks to a Roth IRA. With average stock prices down for 2022, the upside to converting a traditional IRA to a Roth IRA could be enormous. Nevertheless, a traditional IRA owner should not rush into a Roth IRA conversion. Traditional IRA owners considering a Roth IRA owner should be fully aware that a great deal of planning should be done before a Roth IRA conversion is performed.
A Roth IRA is one of the best retirement plans for several reasons. First, all qualified withdrawals from a Roth IRA are federal and state income tax-free. Second, a Roth IRA is the only retirement plan in which there are no required minimum distributions (RMDs). When a Roth IRA owner dies, a spouse beneficiary is eligible to transfer the inherited Roth IRA into his or her own Roth IRA. When the spouse beneficiary transfers the inherited Roth IRA into his or her own Roth IRA, the inherited Roth IRA continues to grow with no RMDs. This is not the case with a non-spouse beneficiary of a Roth IRA. Those beneficiaries must withdraw their inherited Roth IRA within 10 years of the death of the Roth IRA owner, income tax free.
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The question for many traditional IRA owners is: “How much am I willing to pay (in taxes) in order to get a Roth IRA.” Contributions to Roth IRAs are made with after-taxed dollars. With Roth IRA conversions, full income taxes (federal and state) are paid on the amount converted in the year of conversion. One reason that traditional IRA owners whose traditional IRAs are invested in stocks should consider performing a Roth IRA conversion is that when the value of the stocks fall, the taxes due on the conversion amount should decrease. Also, there is a greater potential for asset growth and tax-free withdrawals with a Roth IRA.
There are several factors that an individual should consider in order to determine whether a traditional IRA conversion to a Roth IRA is appropriate and makes financial sense to him or her. The following is a list and an explanation of the key factors:
- Tax rate at conversion verses tax rate at withdrawal. If the tax rate that applies at the time of the Roth IRA conversion is lower than the expected tax rate at the time the IRA assets will be withdrawn, that weighs in favor of a conversion. This means that traditional IRA owners should attempt to perform Roth IRA conversions when they are in lower tax brackets. For example, a conversion could make sense for a retired federal employee who has not started IRA required minimum distributions (RMDs) when the taxable RMDs may push a traditional IRA owner into a higher marginal tax bracket. Also, many financial advisors often recommend doing partial Roth IRA conversions over a period of several years to avoid receiving additional income that may push a traditional IRA owner into a higher marginal tax bracket.
- Value of the traditional IRA. The lower the value of the traditional IRA, potentially the lower the tax bill due on a Roth IRA conversion.
- Avoiding the “widow/widower tax penalty.” The year after a spouse dies, the surviving spouse with no child dependents can no longer file as married filing joint and must file as single. As a result of filing as single, the surviving spouse’s marginal tax rate often increases, even if the surviving spouse’s income has dropped. If this has happened to a married couple during 2022 in which one spouse has died, the surviving spouse may want to consider performing a Roth IRA conversion before the end of 2022.
- State and local income taxes. Since state and local taxes on traditional and Roth IRA contributions vary greatly among the states and the District of Columbia, this is an important consideration when analyzing a Roth IRA conversion. For example, a soon-to-be retiree who plans to move from a high- income tax state such as California or New York to a no income tax state such as Florida or Nevada, may want to wait to perform a Roth IRA conversion until they move to the no income tax state.
- Leaving an IRA to non- spouse beneficiaries. Leaving Roth IRAs to non-spouse beneficiaries such as children and grandchildren will often provide these non-spouse beneficiaries more flexibility compared to leaving them traditional IRAs. Under the SECURE Act that became effective Jan. 1, 2020, most non-spouse beneficiaries must withdraw inherited IRA accounts within 10 years of the IRA owner’s death. Roth IRA beneficiaries can withdraw the entire inherited Roth IRA at the end of the 10 years term – income tax-free. Non-spouse beneficiaries of traditional IRAs must pay federal and state income taxes on all required withdrawals that must be completed by the end of the 10th year following the death of the traditional IRA owner. Non-spouse beneficiaries of a traditional IRA owner who died after age 72 must take required minimum distributions during each year of the 10-year period.
- Potential for future large tax deductions. IRA owners who could be subject to substantial medical expenses in retirement such as lengthy nursing home or assisted living facility confinements, and who are “self-insuring” for nursing home costs by using IRA withdrawals to pay these long-term care expenses, can shelter taxable traditional IRA withdrawals from federal and state income taxes (because of the large medical expense deduction) in order to pay for their nursing home expenses. This may be a reason not to convert traditional IRAs to Roth IRAs since it could bring an unnecessary tax bill resulting from the Roth IRA conversion.
- Potential to minimize other taxes. Receiving tax-free Roth IRA withdrawals could help some individuals minimize other taxes or surcharges. For example, staying below the $200,000 adjusted gross income (single tax filers) or $250,000 adjusted gross income (married filing joint filers) thresholds for the 3.8 percent surtax on net investment income. Another example is Medicare Part B monthly premiums. The higher an individual’s adjusted gross income, potentially the higher the individual’s monthly Medicare Part B premiums. Roth IRA withdrawals are not included in one’s adjusted gross income and therefore will not affect Medicare Part B premiums.
- Age at conversion. Traditional IRA owners who have reached their required beginning date (RBD), at which time they must take annual required minimum distributions from their traditional IRAs, must first take their required minimum distributions in any year before performing a Roth IRA conversion. The Roth IRA conversions will increase taxable income and makes conversions less attractive for traditional IRA owners aged 72 and older.
* Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.
Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.