While the Biden Administration’s current focus is on economic stimulus plans, there is the prospect that tax legislation in the near future may increase taxes on many individuals’ income and estates. As such, one of the planning strategies to consider is to convert some or all traditional IRA assets to a Roth IRA.
The important differences between a Roth IRA and a conventional IRA are in the timing of when the taxes are paid and in the requirement for a minimum distribution later in life. Most IRAs are funded with pre-tax money. The owner pays ordinary income tax on all distributions at prevailing income tax rates in the future. The owner is also required to start taking distributions at a certain age. By contrast, the Roth permits after-tax dollar contributions for retirement where it grows forever tax-free, with no requirement to make withdrawals at any time. If we assume tax rates will rise in the future, it makes sense to hedge against such an increase by converting some portion of Traditional and Rollover IRAs to Roths while income tax rates remain lower than in recent years.
Reasons to Consider a partial or full Roth Conversion
- Pay taxes now at a lower tax-rate
- Avoid paying taxes going forward on all future investment growth
- No required minimum distributions for Roth account owners (you don’t want to be forced to take out money that is growing tax-free if you don’t need to)
- Since the SECURE Act was signed into law in 2019, certain beneficiaries must now take out (and pay tax on!) all the assets of inherited IRAs within 10 years of the original owner’s death. Previously, the required distributions were ”stretched” over the expected life of the beneficiary
- By converting a Traditional IRA to a Roth IRA before death, income taxes will be paid at conversion, leaving beneficiaries an income tax-free inheritance
There are certain things to be wary of when considering a conversion. You must wait 5 years after the conversion before withdrawing any of the converted funds or the withdrawal (including investment earnings) will be subject to a 10% penalty, and income tax may be due on accumulated investment earnings. Additionally, you want to make sure you have adequate funds available outside the IRA to pay the taxes due at the time of conversion.
The above is intended for general information purposes and not as legal or tax advice. Please consult with your professional advisers prior to engaging in any technique described in this blog post.
Please reach out to us at m.oliver@eagleridgeinvestment.com to explore this and other planning strategies at your convenience.