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Partial Roth Conversions
While there are several factors to consider, including income tax considerations, converting a traditional IRA or employer-sponsored retirement account to a Roth can be an effective strategy for many individuals.
While there are income limitations on direct contributions to a Roth IRA, anyone can convert a traditional IRA (or other eligible retirement plan asset) to a Roth IRA provided they pay income tax on the conversion amount. In addition to the potential for tax-free growth, Roth conversions provide an opportunity for individuals to potentially lessen the tax burden during retirement and achieve greater flexibility with regards to IRA distributions after age 70 ½.
Eligibility
Individuals with earned income below certain limits (based on modified adjusted gross income) can contribute up to $6,000 per year to a Roth IRA in addition to catch-up contributions of an additional $1,000 beginning at age 50. While there are limitations on the ability and amount that can be contributed to a Roth IRA, these limitations do not apply to Roth conversions.
Pre-tax amounts converted from a traditional IRA (or another eligible retirement plan) to a Roth IRA are treated as a taxable distribution and taxed as ordinary income in the year of conversion. It should be noted that individuals can convert a portion of pre-tax retirement assets over several years and thus spread the tax impact.
Roth IRA conversions may be worth considering for individuals who:
- Have assets invested in a traditional IRA or employer-sponsored retirement plan
- Expect to be in a higher tax bracket in retirement, or are temporarily in a lower tax bracket now
- Can afford to take the tax hit without using funds in the pre-tax retirement account to pay the income tax generated by the conversion
- Have unused tax deductions (such as charitable contributions or medical expenses) that can be used to offset taxable income generated by the conversion
- Wish to reduce the value of a taxable estate or leave income tax-free assets to heirs
Key Considerations
There are a variety of factors to consider in determining whether to take advantage of partial Roth conversions.
Assets in a Roth IRA have the potential to grow tax-free and can be withdrawn tax-free as “qualified distributions” five years after the initial Roth IRA contribution (or Roth conversion) subject the following qualifications:
- Owner is 59½ or older at the time of the distribution
- Distribution is used for the purchase of a first home (lifetime limit of $10,000)
- Owner dies or become permanently disabled
Since Roth IRAs are funded with after-tax dollars, contributions can be withdrawn tax-free; however, ordinary income tax will be assessed on Roth earnings on distributions which do not meet the above exceptions in addition to a 10% tax on withdrawals made prior to age 59½.
Potential Benefits
Since income restrictions no longer apply to Roth IRA conversions, many individuals should consider including partial Roth conversions as part of their retirement planning. Potential benefits of a Roth IRA include the following:
- Avoid future taxation — Many individuals hold a significant portion of their retirement savings in tax-deferred plans — such as a 401(k) or other employer-sponsored plan — and these funds will be taxed as ordinary income when distributed. Converting some pre-tax savings to a Roth IRA (accomplished through a partial or complete conversion) can offer tax diversification of retirement assets.
- Provide greater flexibility — Roth IRAs offer greater withdrawal flexibility. Unlike a traditional IRA, owners of a Roth IRA are not subject to required minimum distributions (RMDs) beginning at age 70½ (although distributions are required on inherited IRAs regardless of age). Furthermore, individuals with earned income below the MAGI limitations can also continue to contribute to a Roth IRA after turning age 70½ (which is a feature that is not permitted for Traditional IRAs).
Conclusion
Identifying the optimal strategy to take advantage of potential benefits of partial Roth conversions strategy requires careful cash-flow based analysis which considers the tax implications and potential opportunity cost of using investment assets to pay the taxes associated with conversions. When preparing for retirement, it is critical to seek the assistance of a Certified Financial Planner
professional who can help you evaluate various strategies to identify the optimal strategy for your financial situation.
Disclosure: The information provided in this article is for general educational purposes and is not intended to represent tax, legal, or accounting advice. Every situation is unique and it is important to consider the tax implications and potential impact on long-term financial goals before making any decision regarding Roth IRA conversions. Individuals should discuss their unique circumstances with qualified professionals in these areas before making any decision.
