To convert or not to convert? That’s the big question savers should be asking themselves right now as we all adjust to the major reforms of the Tax Cuts and Jobs Act, the most extensive tax rewrite enacted in decades.
If you’ve been thinking about tax diversification — moving your money into more than one savings bucket to avoid a huge tax bill in retirement — the act’s new tax brackets and lower tax rates may provide the nudge you needed to convert a traditional IRA to a Roth IRA.
Let’s say you’re filing as a single individual, and your taxable income is $150,000. In 2017, your tax rate was 28%. In 2018, your tax rate will be 24%. If you’re married filing jointly, a $150,000 taxable income puts your 2017 tax rate at 25%. In 2018, it will be 22%.
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That’s a substantial savings. Which is why many advisers are talking to their clients about using this opportunity to convert some of their tax-deferred savings (from traditional IRAs, 401(k)s, etc.) to a Roth account as a hedge against future tax hikes.
Yes, the notion of paying taxes on that money now might be a bit painful. No doubt you’ve enjoyed watching all or most of your savings grow untouched by the IRS for so long. But remember: The dollar amount you see at the bottom of your IRA statement every quarter doesn’t all belong to you. Uncle Sam will come calling in a few years anyway, when you start making withdrawals — or at 70½, when you must begin required minimum distributions (RMDs).
Converting to a Roth IRA will guarantee that you owe no additional income tax on the converted funds — as well as no taxes on any money those funds earn before you withdraw them — during retirement. The balance in your portfolio will be yours to use as you wish. There are no RMDs with a Roth, so if you don’t need the money, you can let it grow untouched to leave to your heirs.
Of course, you should consult with your tax professional to determine what the new tax rates will mean for you, and if it makes more sense to pay income tax now or to wait until after retirement. So, if you’ve been curious about doing a Roth conversion, here are some things you should know:
1. There are rules.
There are different requirements for Roth contributions and Roth conversions regarding when you can access your funds. Generally, converted assets in a Roth IRA must remain in the account for five years (if over 59½) to avoid taxes on any gains, so it’s strongly recommended that you do each conversion with money you’re sure you won’t need for at least that long. If you need to withdraw the money within that timeframe (each conversion has its own holding period), you could end up owing additional taxes you hoped to reduce.
2. Maintain discipline and don’t touch the rollover money.
If the same trustee controls your old and new accounts, you can request a same-trustee transfer. Otherwise, you can arrange a trustee-to-trustee transfer. If you choose to do your own rollover, move the conversion money to your Roth IRA within 60 days. If you miss the time limit, the IRS will tax the withdrawal as income, and if you’re younger than 59½, you’ll also have to pay a 10% early withdrawal penalty.
3. You can’t change your mind.
In the past, you could undo your decision to move to a Roth, but the new reforms got rid of this “recharacterization” option. Be cautious: Make sure the amount you convert won’t bump you into a higher income tax bracket and that you’ll be able to pay the taxes on your conversion.
4. Watch out for a domino effect.
If you do push yourself into a higher tax bracket with your conversion, and you’re already in retirement, the additional income could also affect the taxes on your Social Security and what you pay for Medicare.
5. Include estate planning in your decision-making.
Talk to your financial adviser, estate attorney and/or tax professional about how your heirs’ taxes could be affected if they inherit a Roth versus a traditional IRA. Note that the five-year holding period for qualification continues after the owner’s death.
Although conventional wisdom suggests that a worker’s gross income will decline in retirement, taxable income sometimes does not. Think about it. You’ll be collecting Social Security and pension payments, maybe do some part-time work or decide to sell some assets. When your children are grown or if your mortgage is paid, you’ll lose some valuable tax deductions and credits. And if your spouse dies, your filing status will change.
No one knows what future rates will be, but many of the breaks offered under the current tax plan will expire in 2026. That window may be even narrower if there’s an administration change after the 2020 presidential election. And many experts predict that rates eventually will have to go up to help pay for the nation’s $21 trillion (and growing) debt.
Diversifying your tax situation with a Roth can help you prepare for whatever may happen down the road. Just as proper asset allocation offers proactive protection for your portfolio, figuring out the right pre-tax/after-tax mix can keep more of your hard-earned money now and in retirement. Talk to your adviser about the pros and cons of adding a Roth IRA to your financial plan.
Kim Franke-Folstad contributed to this article.
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