Welcome to the Weekly SUMmary - 11/20/2020
Today I'm going to talk about Roth Conversions, the "Backdoor Roth", "Loophole" and any other name that one can come up with for this strategy.
What is a Roth Conversion?
Simply stated, it's taking pre-tax retirement account assets and "converting" them to Roth assets. This sounds a lot more complicated than the actual process. One is not literally changing dollars. It is a designation of what those assets are in the eyes of the IRS. But of course, our industry can complicate anything (rightly so, those making the process possible are only doing paperwork necessary to ensure that the IRS views this for what it is and those converting do not feel any negative implications or the incorrect process [which could include additional taxes and penalties]). For more information on how a Roth functions, see this previous blog post.
Why would one consider a Roth Conversion if they'll just owe more in taxes now?
- The point is to pay the taxes now, instead of later. This is quite literally hedging your bet that the amount you pay in taxes will be higher in the future than now. Does this mean that tax rates will be higher? Not necessarily. Income could be higher, deductions or credits lower, or any other number of reasons. BUT, if you think tax rates will be higher, it makes the decision less complicated. (To see a comparison, see John and Jane Doe's situation in this previous post here.)
- Required Minimum Distributions (RMDs). In a traditional pre-tax retirement account, taxes have never been paid on those assets. The government wants to ensure that taxes are paid, so at a certain age, they require distributions, so those distributions can be taxed. This is not the case for the owner of Roth assets1. Therefore, if you convert pre-tax dollars into Roth dollars, when you reach that age, your total income will be lower (in the eyes of the IRS, as you've already paid income taxes with this strategy). This is where true "Retirement Planning" comes in. Most people think it is "help me save as much as possible until retirement." It's quite the opposite. How do you create income from everything you've done previously in life?
- Beneficiaries should not have to worry about taxes. Let's look at a $100,000 IRA vs a $100,000 Roth IRA. If a non-spouse beneficiary2 inherits an IRA, they will need to pay ordinary income taxes on distributions in a maximum time frame of 10 years (recently changed with the SECURE Act, see previous blog here). Assuming the heir's tax rate is 25%, they will end up ultimately receiving $75,000. This is great, but not as great as the original $100,000, which is how the Roth would pass (no taxes)3. That said, the government won't allow infinite potential for tax free growth (how Roths work), so ten years from death of the original owner, the beneficiary will have to draw down the account in the form of RMD.
| Trad IRA | Roth IRA | |
| Initial Value | $100,000 | $100,000 |
| Taxes @ 25% | $25,000 | $0 |
| Total Received | $75,000 | $100,000 |
This chart assumes inheritance, not factoring in taxation of contributions into either account. For more information on this, see previous blog post here.
There are many other considerations in regards to your specific situation. Conversions may not be suitable/appropriate for you at this time. Please consult with your team of advisors (tax professional, financial consultant, etc) prior to making any changes.
1. See bullet #3 in this blog. RMDs are required for beneficiaries.
2. Beneficiaries are complicated, see the referenced SECURE Act blog or discuss with a professional about inheritance of specific beneficiaries.
3. Roths have specific rules. No tax will be collected on growth as long as one has Qualified distributions from the Roth.
As always, any information provided in this and any other blog should not be considered advice or recommendation, but educational in nature. Information provided is based on experience in industry, continuing education, advanced degrees and further studies.
Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
You may take nontaxable withdrawals before age 59½ if the Roth IRA is held for at least five years and you meet certain distribution guidelines. Otherwise, an early withdrawal before age 59 ½ may be subject to taxes and a 10 percent federal tax penalty. Please discuss with your tax advisor prior to making financial decisions.
(11/20)