TRADITIONAL VS ROTH IRA
While there are several key differences between traditional and Roth individual retirement accounts (IRAs), including eligibility requirements and accessibility of funds contributed, the biggest difference is the tax treatment of distributions. In a traditional IRA, the individual receives an immediate tax advantage as contributions are deductible in the year in which they are made and future withdrawals are considered taxable income. With a Roth IRA, the individual contributes post-tax dollars and the assets and withdrawals, including investment income, are generally exempt from federal and state income tax.
WHAT IS A ROTH IRA CONVERSION AND WHO IS ELIGIBLE?
In a Roth IRA conversion, an individual withdraws assets from their traditional IRA or qualified retirement plan (QRP) and deposits the funds into a Roth IRA. The conversion, as with other distributions, triggers an immediate tax liability that is taxed as ordinary income. The amount subject to tax is generally the value of the assets on the day of the conversion. However, if the account owner was not able to take a deduction for all or a part of the funds contributed to the traditional IRA or QRP, the calculation is more complex and should be discussed with your advisor. A Roth IRA conversion can be staged over multiple years in order to stagger the tax liability.
Anyone with a traditional IRA or QRP is eligible to make a conversion, even if the individual would be precluded from contributing to a Roth IRA. Even individuals who are under the age of 59 ½, who generally pay a 10 per cent penalty on receipt of a taxable distribution from their traditional IRA or QRP, can convert to a Roth IRA without incurring a penalty (see below Important Cautions regarding time requirements).
WHO SHOULD CONSIDER A ROTH IRA CONVERSION?
- Expect that income from retirement plan distributions will be subject to higher tax rates in future years – either during retirement or in the hands of an inheritor (if the named beneficiary of the account is a trust, tax is paid at the highest rates with just $12,500 in income, and if the named beneficiary is an individual, they may receive income during their peak earning years). Anyone considering naming a trust as a beneficiary for a retirement account should seek professional advice to ensure that the trust is properly structured to achieve the desired outcome.
- Want to maximize their estate for heirs, since Roth IRAs are not subject to lifetime required minimum distributions (RMDs) and thus the assets can build additional value by compounding in a tax-favored vehicle. Note that, as with traditional IRAs and QRPs, the Roth IRA is included in the account owner’s taxable estate and, after the account owner’s death, there are RMD requirements that apply to beneficiaries.
- Have portfolios that have declined in value, therefore presenting an opportunity to pay less tax on a Roth IRA conversion compared to when stock prices are high.
- Have other losses or deductions to offset the tax due on the conversion.
- Have little to no tax diversification of retirement accounts.
- Want to benefit from having less taxable income in retirement years, such as reduced Medicare B premiums.
- Have taxable estates and do not want their estates to pay tax on deferred income within their traditional IRA or QRP. Paying the income tax at the time of conversion also reduces assets that would otherwise be subject to estate tax.
WHEN DOES CONVERSION MAKE LESS SENSE?
- Expect that income from retirement plan distributions will be subject to lower tax rates in retirement or after death.
- Plan to give a substantial amount of the retirement plan assets to charity.
- Are nearing or in retirement and need access to the assets.
- Are currently receiving social security or Medicare benefits.
- Have college-age children that will be applying for financial aid.
- Do not have funds outside of the retirement account to pay the income tax that will be triggered by the conversion, especially if they are under age 59½.
- May be pushed into a higher income tax bracket by the income from the Roth IRA conversion, in which case doing the conversion over multiple years could be considered.
Though distributions from the Roth IRA are generally exempt from federal and state income tax, there are times when taxes or penalties may be imposed. Every situation is different and we would encourage anyone considering a Roth conversion to review their situation carefully with their advisors.