Roth IRA accounts have two main advantages, tax free withdrawals (if certain rules are met) and no required minimum distributions for your life! The Tax Cuts and Jobs Act implemented condensed, lower marginal tax brackets that are set to expire at the end of 2025 (or potentially sooner if the political climate changes). We believe that the current tax rates are the lowest they will be for the foreseeable future. Converting part (or all) of your Traditional IRA to a Roth IRA can safeguard you against higher future tax rates and a higher future tax liability forever.
Let’s start by going over some of the similarities and differences between Traditional IRAs and Roth IRAs to determine if a conversion makes sense for you. Roth IRAs and Traditional IRAs are similar in many ways. For example, the contribution limits are the same ($6,000 for 2019 with a $1,000 catch up for those over the age of 50), both types of accounts have the same rules around the types of investments that are permitted (or prohibited) and both account types require that the owner have earned income in the year of the contribution. In fact, a taxpayer can have both a traditional and Roth IRA account and contribute to both, although contribution amounts are aggregated.
There are several key differences between the two types of accounts. First, Traditional IRA Accounts are typically funded with pre-tax money while Roth IRA accounts are always funded with after tax money. Another key difference is that only taxpayers with a modified adjusted gross income (MAGI*) below certain levels are permitted to make direct contributions to Roth IRAs. For 2019, contributions are phased out for taxpayers with MAGIs as follows:
- Married Filing Jointly: Phaseout begins $193,000 – $203,000 completely phased out
- Single: $122,000 – $137,000
- Married Filing Separately: $0 – $10,000
In addition, taxpayers may continue to contribute to Roth IRAs beyond the age of 70 ½ (as long as there is earned income and they are below the MAGI levels) and finally, as mentioned earlier, Roth IRA accounts are not subject to mandatory distribution rules (RMDs) during the owner’s lifetime like Traditional IRAs are.
If you are like many taxpayers in high income earning states like California, your MAGI is potentially above the amount that will allow you to make direct contributions to a Roth IRA. In last month’s article we described a technique that some may refer to as a “backdoor Roth” (making after tax contributions to a traditional IRA and then immediately converting to a Roth IRA). A Roth conversion is another technique used to get money into a Roth IRA if you are in a circumstance where you do not have earned income or your MAGI is above the limit. The process is simple and straightforward. You take a taxable distribution from your Traditional IRA and transfer it to your Roth IRA within 60 days. The 10% premature withdrawal penalty does not apply, but the amount of the distribution will be part of your taxable income on your tax return in the year of conversion.
The decision about whether (and how much and for how long) to convert a traditional IRA to a Roth IRA requires detailed tax and accounting analysis. The conversion generally benefits people with a large portion of their net worth in qualified accounts or those lucky enough to have a deferred compensation plan (like a pension) where Required Minimum Distributions (RMDs) are above the amount needed for cash flow purposes, or a year when taxable income is very low (the first few years of retirement – before RMDs and Social Security kick in), or where a legacy is desired for future generations. If you anticipate being in a higher tax bracket in retirement, now may be a great time to consider converting to a Roth. The ability to pay the tax liability with money outside the IRAs is a plus.
If you have a Roth component in your 401(k) or 403 (b) plan, or government Section 457 plan, please contact our office so we can help you assess whether you should convert part of your pre-tax dollars to after-tax within your plan.
At Seaside, we work with your tax preparer (whether that is yourself or a CPA/EA) to take advantage of “room” left in your last marginal tax bracket to effectively keep your tax bill as low as possible, both now and in the future. If you would like to explore this strategy in more depth, contact our office and we would be glad to help you make an assessment.
*MAGI (Modified Adjusted Gross Income) is a Adjusted gross income plus certain add back items such as foreign income, foreign-housing deductions, student load deductions, IRA contribution deductions and deductions for higher education costs.