Over the past several months clients have called me regarding converting their IRA, 401k, 403b or other retirement accounts into a Roth, but these conversions can have serious tax implications.
The Tax Problem
One case involved converting an IRA into a Roth IRA. The client was passionate about the idea of tax-deferred growth and tax-free income upon retirement. His reasoning was sound, although he did not understand the tax implications of a conversion. Conversions create a 1099, increasing your taxable income by the account value converted and payable in one year. In this specific case, my client’s IRA was worth about $100,000. Once he understood his income would increase dollar for dollar beyond his earned income – and he would owe additional tax on the conversion — he decided not to convert.
Watch Out For the Roth Rules
A Roth retirement account allows for tax-deferred growth combined with tax-free distributions during retirement. There are several rules governing conversion and tax-free distributions from such accounts. Aggregate rules will not be discussed because they are numerous. However, the government has eased limitations to qualify for a Roth conversion.
Why has the government eased rules like income cap disqualification for Roth conversions?
My opinion is the need for tax revenue. One argument in favor of converting now is that it will sidestep higher expected taxes at retirement. Taxes cannot be predicted, especially since the tax code frequently changes, so further thought should be made about the investor’s unique situation before considering a full or partial conversion.
This does not mean a Roth conversion never makes sense. Many investors are in a position to pay the tax upon conversion without it affecting their overall tax liability. It is important to be aware of the uniqueness of each investor’s situation when making such a decision.
Starting a Roth IRA
Starting a Roth IRA for an investor can often be a wonderful tool. They may make nondeductible contributions and allow their investment to grow tax-deferred until retirement. At retirement income withdrawn from their account is also tax-free.
Can I Contribute to a Roth IRA?
If you are making maximum contributions to a Traditional IRA or another retirement account you may not contribute to a Roth IRA. There are exceptions to this rule such as not maximizing contributions to an IRA, which would allow an investor to make contributions to a Roth IRA subject to deferral rules established by the IRS.
Roth IRA’s can be beneficial for investors, but if you are considering a conversion, consult with a well vetted financial planner and CPA. Their job is to inform, protect and help you reach a well thought out plan. As always, I am available for second opinions or to answer questions.
This information is not intended to give specific recommendations, investment, legal or tax advice. Advisory services offered through Nepsis Advisor Services, Inc.; an SEC Registered Investment Advisor.