By Erica Eros | Qualified Plans
Converting a Traditional IRA or employer-sponsored retirement account to a Roth IRA may offer more flexibility at retirement for the Roth IRA owner. Roth IRAs have no required minimum distributions, and post death distributions to beneficiaries are tax-free. Because tax rates are historically low, it may be a good time to consider a Roth IRA conversion.
- Doing one large conversion may push the taxpayer into a higher tax bracket but doing partial conversions will allow for the tax payments to be spread out over several years.
- Use non-IRA funds to pay for income tax on conversion.
- There is no income limit on eligibility for converting a Traditional IRA to a Roth IRA.
- When doing a Roth conversion of any nondeductible retirement account, you must consider what the client has in any pre-tax traditional, SEP, or SIMPLE IRA accounts. Any pre-tax balances in these accounts would require the use of Pro Rata Rules on the conversion.
- Married tax filers have the most favorable tax bracket. Couples should consider a Roth conversion before the first spouse’s death.
- Upon conversion, pre-tax contributions are taxed as ordinary income and after-tax contributions are not taxed. The pro-rata formula is used to determine how much of a conversion is taxable when the account holds both pre-tax and after-tax contributions. The rule combines all SEP, SIMPLE and Traditional IRAs as if they are one.
- The pro-rata share (tax-free portion) is calculated starting with the sum of all after-tax dollars in all Traditional IRAs. Divide the sum of after-tax dollars by the 12/31 balance of all Traditional IRAs. Then multiply that percentage by all Traditional IRA distributions. The following example illustrates the pro-rata calculation:
If you have $20,000 of after-tax dollars in all your IRAs and the total balance of all your IRAs is $100,000, your percentage of after-tax dollars is 20% ($20,000/$100,000 = 20%). If a distribution of $10,000 were made, the tax-free portion would be $2,000 (20% x $10,000 = $2,000). The remaining portion of the distribution ($8,000) would be taxable at ordinary rates.
While there are many benefits of doing a Roth conversion, there are also situations where a conversion may not make sense:
- Does the IRA owner need the IRA funds to meet annual living expenses? A five-year holding period applies to earnings in the account.
- Will the conversion push the IRA owner into a higher tax bracket? Calculate the Alternative Minimum Tax (AMT) implications of the conversion.
- Will the client die with a substantial charitable bequest?
- The Tax Cuts and Jobs Act passed in December 2017 eliminated the ability to recharacterize or undo a Roth conversion.
It is always a best practice to have the client’s tax professional run the numbers to verify any tax consequences of a Roth conversion and the optimum conversion amount.
If you have any questions, contact us in Case Planning – Qualified Plans by email at QPinfo@bdops.com.
We DELIVER great service to independent representatives! If you would like to know what else makes our family special, we would love to chat! Contact Kristi Delongchamp at (888) 744-6264 or firstname.lastname@example.org.
About SPS Family
The SPS Family consists of two broker-dealers, Sigma Financial Corporation and Parkland Securities, LLC; a Registered Investment Advisory firm, Sigma Planning Corporation; and a back office, known as BD Ops, LLC. The companies, based in Ann Arbor, Michigan, are under common ownership and led by an experienced executive team. The SPS Family prides itself on personal service to independent registered representatives and investment adviser representatives from across the United States. We consider our representatives family as we strive every day to provide them “Independence. DELIVERED.”
300 Parkland Plaza | Ann Arbor, MI 48103 | 888-744-6264