If you are like most Americans, retirement planning is a top financial priority, and saving for retirement in Roth IRAs can be one of the best strategies. Roth IRAs can be funded through contributions, rollovers, or conversions. A Roth IRA conversion is the movement of cash or securities from a traditional, SEP, or SIMPLE IRA (over two years from the first SIMPLE IRA contribution date) or Qualified Retirement Plan (QRP) to a Roth IRA. The following information will outline eligibility, taxation, benefits, and considerations when executing a Roth conversion strategy.
- Generally, all traditional, SEP, or SIMPLE IRA owners (over two years from the first SIMPLE IRA contribution date) and QRP participants (upon a triggering event) are eligible to convert their IRA or QRP to a Roth IRA, regardless of their Modified Adjusted Gross Income (MAGI) or age. If an individual is age 73 or older, the annual RMD must first be fully satisfied before doing a Roth conversion. RMDs are not eligible for conversion.
- Married couples filing jointly, separately, or single filers are all eligible for Roth conversions.
- No earned income is required to do a Roth conversion.
- Beneficiary IRAs inherited by a non-spouse may not execute a Roth conversion; however, non-spouse beneficiaries of a QRP may convert their pre-tax inherited QRP to a Beneficiary Roth IRA.
- All pre-tax IRA or QRP assets being converted are taxable as ordinary income for the year of conversion.
- Non-deductible IRA contribution/conversion strategy (Backdoor Roth) – If you are not eligible to make a Roth IRA contribution because your MAGI is over the eligibility limit, consider making a traditional IRA non-deductible contribution of $6,500 (plus $1,000 catch-up if age 50 or older) each year for the purpose of a conversion. Converting this $6,500 or $7,500 contribution (plus the earnings) to a Roth IRA penalty-free will only require you to pay ordinary income tax on the earnings. If you are married, this same strategy may be applied to your spouse’s IRA.
- If your IRA(s) contain both pre-tax and after-tax assets, the value of all of your IRAs (not including Roth IRAs or Beneficiary IRAs) must be aggregated to determine the taxable versus non-taxable portion of any conversion, and this includes traditional, rollover, SEP, or SIMPLE IRAs. This is known as the IRA pro rata and aggregation rule.
BENEFITS OF A ROTH IRA:
- Tax-free growth and withdrawals – Converting to a Roth IRA allows for assets to compound tax-free. Roth IRA assets (including earnings) that remain in a Roth IRA for five years and until the owner reaches age 59½ can be withdrawn tax-free and penalty-free.
- No Required Minimum Distributions (RMDs) – Mandatory distributions are not required from Roth IRAs. Distributions will only occur if requested by a Roth IRA owner or after death when non-spouse beneficiaries of Roth IRAs must begin RMDs.
- Hedge against future tax rate hikes – By locking in the taxation on a Roth conversion today, the IRA owner is eliminating the risk of paying taxes upon IRA distribution in the future if tax rates increase.
THINGS TO CONSIDER:
- Can you pay the taxes due from non-IRA assets? If federal or state tax withholding is done from the IRA upon conversion, and the IRA owner is under age 59½, a 10% penalty will generally apply on the withholding.
- How old are you? Generally, Roth conversions are more beneficial for younger investors, as there is a longer time horizon to compound tax-free Roth IRA earnings.
- Are you in a lower tax bracket now compared to when you will begin taking Roth IRA distributions? Paying taxes at a lower tax rate now makes Roth conversions more appealing for the current tax year.
- Is providing tax-free assets to heirs important to you? Roth conversions can be used as an estate planning tool.
- While Roth conversions may be a great opportunity for many IRA owners, an individual must be able to pay the taxation on the conversion. Once a Roth conversion is processed, there is no way to reverse or recharacterize the conversion and ordinary income taxes will generally be due for that year.
Since there is no MAGI or age restriction for conversions, most retirement savers can take advantage of the many benefits of a Roth IRA. Contact your Stifel Financial Advisor to discuss how a Roth conversion may benefit you.
This information is for educational purposes only. Stifel does not provide legal or tax advice. You should consult with your legal or tax advisors regarding your particular situation.