Blog Roth IRA Conversions

By Cowles Liipfert & Don Wells

Should you consider converting your retirement account into a Roth IRA account as you approach or enter retirement?

Most IRAs and 401(k) accounts are pre-tax accounts: you can deduct your contributions to those accounts on your personal income tax returns in the year contributed, and the funds in the account grow tax-free until you make withdrawals, which are fully taxable in the year of withdrawal. 

Contributions to Roth IRAs, however, are not deductible in the years in which they are made, but when eventually withdrawn, they are non-taxable. 

You can convert a pre-tax account into a Roth IRA account, at which time the funds withdrawn from the pre-tax account to fund the contributions are taxable, and the contributions to the Roth IRA are not deductible.  Taxes are paid on the conversion at your current marginal rates, which can push you into a higher income tax bracket and can cause high tax liability for the year in which the conversion is converted.

Despite the high tax in the year converted, a Roth IRA conversion can sometimes be a smart move because:

• The conversion is not subject to income caps applicable to high-income taxpayers.  Most taxpayers can make annual contributions up to $7,000 per year ($8,000 for taxpayers age 50 or older), but higher-income taxpayers are subject to limits based on income, and sometimes annual Roth contributions are not allowed at all.  Roth IRA conversions – as distinguished from annual contributions – are not subject to those limits.
• Roth IRAs are not subject to required minimum distributions (RMDs), which are mandatory withdrawals applicable to regular retirement accounts, starting at age 73.
• At death, the remaining balance in your Roth IRA may be transferred to named beneficiaries.  This is discussed in more detail below.

There are disadvantages to Roth IRA conversions, including:

• In the year of the conversion, you will have to pay at your marginal rates income tax on the entire amount withdrawn from your ordinary retirement accounts.  If paid from the funds withdrawn, then a reduced amount would be available for transfer to a Roth IRA, but the tax may be paid from other funds, if available, in which case the entire amount withdrawn can be rolled oner into the Roth account.
• A Roth account must be open for at least 5 years before withdrawals may be made without paying income tax on the withdrawal, plus withdrawals before age 59½ are subject to a 10% penalty, in addition to ordinary income tax.
• Once a regular retirement account is converted to a Roth IRA account, the conversion cannot be undone. Also, it is possible that a taxpayer may be in a lower income tax bracket after retirement than in the year of the Roth conversion, resulting in higher up-front taxes on the conversion than on the withdrawals later.

If you do not need to make withdrawals from your IRA after reaching retirement age, income and capital gains can be accumulated inside the Roth IRA account.  If your investments inside the Roth account grow at the historical rates of 7% to 10% per year, the account can double or triple in value in 10 to 20 years.

Consequently, your Roth IRA can be a wonderful gift for your beneficiaries at death.  The beneficiaries after your death will not be allowed to continue to postpone taking withdrawals indefinitely, but will generally be subject to 10-year withdrawal rules, unless they fall under one of the exceptions to the rule.

Deciding whether or not to convert regular retirement accounts to Roth IRA accounts should be carefully evaluated, so you should consult with a qualified financial advisor before making such a decision.

If you do not already have a qualified financial advisor to help you make such a decision, you can consult with your attorney or CPA, or perhaps find one online.

To consult with one of our firm’s attorneys, please call 336-725-2900.