Questions Regarding Roth Conversions
Roth conversion creates a taxable event in the year of conversion. For that reason, it’s critical to address each and every tax and planning detail with a knowledgeable tax advisor. Here are some of the key points:
Offset the Tax on the Conversion
Net operating loss carry forwards, charitable contribution carry forwards, non-refundable tax credits, and pass-‐through losses could reduce, and in some cases, even eliminate the conversion tax liability. Individuals who experience a large income drop can use the temporarily low marginal rate to provide an opportunity to convert at a lower rate.
Penalties, RMDs, and Indirect Rollovers
Conversion transaction in and of itself does not trigger a premature IRA distribution penalty, even if you are younger than 59½. However, when paying taxes with IRA assets, beware of the 10% penalty applicable to distributions prior to age 59½. Converting to a Roth IRA and then taking a distribution out of the Roth does not provide relief from the 10% penalty.
Required Minimum Distributions (RMDs) cannot be converted. If your client is 70½ or older, he must take his current year RMD before proceeding with a conversion.
The ideal way to move money from a traditional IRA to a Roth IRA is by means of a direct rollover, through a trustee-to- trustee transfer or an internal conversion. In this type of transaction, instead of your client receiving a check, funds are transmitted from one institution to another or from one account into another. If your client does end up with a check from her IRA, as is the case with an indirect rollover, the funds must be deposited it into another retirement account, including a Roth IRA, within 60 days. Failure to do so will result in negative tax consequences and will prevent client from ever rolling over or converting the funds. If you do find yourself missing this important deadline, you can request that the IRS give you a pass, but it may be a costly endeavor.
The 5-Year Clock and Access to Funds
If your client needs to access her retirement money within the next five years, you should be careful with the conversion strategy. Roth dollars only become entirely tax-‐free after meeting both of the following conditions: 1) five years from the initial Roth deposit or conversion, whichever applies to the amount in question, and 2) a qualifying event such as turning age 59½. Each conversion is subject to its own five-year window.
Beware of Non-deductible Contributions and Multiple IRAs
If your client has a non-deductible IRA and wishes to convert that account to Roth, ordinary income taxes are only owed on earnings converted to your Roth IRA. However, you cannot convert only the non-deductible portion of an account and leave the taxable portion behind. The income recognized from conversion is calculated by first looking at the percentage of the account that is non-deductible and then multiplying that percent by the amount of the conversion.
Conversion Can Be Undone
You have until October 15 of the year following the conversion to reverse it. This reversal is known as a re-characterization. To make the most of this strategy, the conversion amount may be divided among separate Roth IRAs, e.g. one per asset class. By April 15 following the year of conversion, tax is paid on the entire amount converted and your tax return is extended. By October 15, the underperforming accounts are re-characterized and a tax return reporting conversions and re-characterizations is filed. Ordinary income tax associated with the re-characterized assets is eliminated. This planning mechanism offers a measure of downside protection. It is mostly cost-effective for larger IRA balances. The ability to re-characterize only underperforming assets is not available if all converted assets reside in one account. The IRS requires all gains and losses be prorated over the entire account balance.
Overcoming Roth IRA ‘Ineligibility’
To make contributions directly to a Roth IRA, your client must have income below a certain range. This range varies depending on one’s filing status as discussed earlier. The new conversion rule effectively allows anyone, even those who are married filing separately, to make a Roth IRA contribution despite the phase-out rules. Here’s how: Anyone who has compensation and is younger than 70½ may make a traditional IRA contribution. Factors such as eligibility to participate in an employer’s plan and income levels determine traditional IRA deductibility, not whether a contribution may be made. Under the new regulations, that non-deductible IRA could immediately be converted to Roth. If client has other IRA accounts, the taxable income resulting from this transaction will be computed based on their total value as discussed above.
Conversion May Reduce Tax on Social Security Income
Social Security dollars can be partially taxed when income is above a certain threshold. Distributions from traditional IRAs are added in when determining income for this purpose. Distributions from Roth IRAs are not included, potentially helping your client reduce the income tax bite even more.
A Roth Conversion May Increase the After-Tax Value of Estate
If your client does not need Roth accumulations and wishes to leave a financial legacy, you may find Roth accounts indispensable. Roth accounts grow tax-free and RMD-free until the day they are turned over to heirs. A surviving spouse can continue the tax-free and RMD-free pattern. Non-spouse heirs (children, grandchildren, etc.) can extend the Roth’s benefits by taking tax-free minimum distributions over their life expectancies, leaving the bulk of the account intact to continue tax-free growth.
If you have a question that was not addressed above, reach out to your Retirement Services subject matter experts via email firstname.lastname@example.org or by calling (888) 926-0600. We are happy to help!
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