Roth Conversion – Opportunity and Caution

Should you convert your IRA or 401(k) to a Roth?  The decision to convert is specific to each investor’s set of circumstances.  This post shares some key factors to consider for the Roth decision.

What is a Roth Conversion?

A Roth conversion is a transfer of money from an IRA or 401(k) to a Roth.  In general, you have to pay taxes on the amount you convert – this is the cost.  The benefits are twofold:

  1. No taxes on future earnings and qualified withdrawals.

  2. No requirement to withdraw money after age 70.

Reasons to Convert

Temporary Income Opportunity

If your income is temporarily low for the year, a Roth conversion can make a lot of sense.  Temporarily low income (by choice or misfortune) allows an investor to take advantage by paying a lower income tax rate on the Roth conversion.

Long-Term Income Planning

Take a close look at your retirement income plan.  Your taxable income may increase over time – especially in your 70’s and 80’s.  This income “problem” happens when an investor has been successful in growing a multi-million dollar tax-deferred portfolio.

For example, if an investor is age 70 and owns a $2,000,000 IRA, the required distribution is $73,000.  After adding a joint Social Security benefit of $40,000, this investor could have over $110,000 more income at age 70 than in their 60’s.

Extra income is not a bad problem to have, but this tax burden is something that may be avoided.  Converting a portion of the IRA to Roth during your 60’s may be a great way to save taxes in the long-run.

Generational Wealth Transfer

For those subject to federal and/or state estate tax, a Roth Conversion may save your family estate taxes.  The income tax on the Roth conversion is money spent, but is no longer a part of your taxable estate.  Years later, the Roth is tax-free income for beneficiaries!

Reasons for Caution

Alternative Minimum Tax (AMT)

If you pay AMT or the Roth conversion pushes you into AMT, a conversion could cost more tax than expected.  Depending on the amount of income in AMT, the tax rate on a Roth conversion may be 26%, 28%, or 35%!

New Taxes and Phase Outs

2013 is the first year for the Medicare surtax and a comeback for phase-outs to deductions and exemptions.  These tax increases affect individuals with $200,000 of income and couples/families with $250,000 of income.  Investors may want to plan around these taxes.

College Tax Credits, Financial Aid, and Insurance Subsidies

There are financial incentives to keep income low for college and health insurance purposes.  Converting an IRA to a Roth may prevent an unknowing investor from realizing these benefits.

The American Opportunity Tax Credit, Lifetime Learning Credit, and Tuition and Fees Deduction are all valuable tax savers for college education costs.  Each benefit has its own income limit and may be more valuable than a conversion.

Financial aid offices review income and net worth information on the FAFSA to make decisions on grants and scholarships.  If an investor’s net worth does not disqualify their child from financial aid benefits, there is a good chance that income from a Roth conversion  will.

If an investor needs health insurance and is able to keep their income low, they may qualify for a tax credit subsidy.  For example, a 60 year-old couple with $60,000 of income would qualify for an $8,000 health insurance premium subsidy, regardless of net worth.  In this case, the future tax savings of a Roth conversion can take a back seat to cash back subsidy today.

The decision to convert a tax-deferred account to a Roth requires a full check-up on an investor’s net worth, portfolio, income, and circumstances.  By considering several key factors, an investor may have a general idea if this advanced planning strategy is right for them.  If a Roth conversion is right for you, a financial advisor can help you take the necessary steps and possibly use additional strategies to add value to the conversion.

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