Roth Conversions
Whenever you make contributions into a Traditional IRA, or into an Employer-Sponsored Defined Benefit Plan (i.e., 401(k) plan, 403(b) plan, etc.), the amounts of the contributions are deducted from the taxable compensation that you receive. Any income taxes due on these contributions are deferred until you begin to take distributions from your Plan once you’re retired, and presumably, in a lower federal income tax bracket.
The deferral of any income taxes due on the retirement contributions made is a timing issue. You opt to pay those income taxes at some future time rather than pay them when you receive the income.
In making a Roth Conversion, you opt to pay the income taxes due on amount being converted now. Why? Because you would like the converted Roth IRA funds to capitalize on The Power of Compounding and grow tax-free for the rest of your lifetime. That’s a very compelling argument for considering such a conversion. The drawback to making a Roth Conversion: you will incur significant federal and state income tax liabilities that you must pay in the year that the conversion takes place.
Suppose that you plan to convert $100,000 from a Traditional IRA into a Roth IRA. You are in the 20% Federal income tax bracket, so your federal income tax liability would be $20,000. Your state income tax liability would be an additional 5% or $5,000. If you pay both income tax liabilities with funds from the converted Roth IRA, your account will have a remaining balance of $75,000.
In general, there are two sets of circumstances in which making a Roth Conversion would make good financial sense:
- During a down economy. Your overall taxable income is likely to be lower, which would put you into a lower federal income tax bracket.
- You’ve had a particularly good year financially. You have the funds readily available to pay whatever income tax liabilities may be incurred because of the conversion. And you want to capitalize on The Power of Compounding and grow these funds tax-free for the rest of your lifetime.
Tax Tip
Use funds that you have available from sources other than the converted Roth IRA funds to pay the Federal and State income tax liabilities incurred by the Roth Conversion. This will allow the converted Roth IRA funds capitalize on The Power of Compounding and grow tax-free for the rest of your lifetime. Let’s examine why this approach is a good idea.
Let’s use the $100,000 Roth IRA conversion that is discussed above.
Assuming an investment rate of return of 5.0% APR, compounded monthly, it would take 5 years and 9 months for your converted Roth IRA account balance to compound and grow back to its initial $100,000. On the other hand, if you had paid both income tax liabilities with other funds, your converted Roth IRA account balance would have compounded and grown to $133,229 during that same time. This would represent an increase of $8,229 over the $25,000 that you had paid, a return of 32.9%.
Assuming an investment rate of return of 8.0% APR, compounded monthly, it would take 3 years and 7 months for your converted Roth IRA account balance to compound and grow back to its initial $100,000. On the other hand, if you had paid both income tax liabilities with other funds, your converted Roth IRA account balance would have compounded and grown to $133,071 during that same time. This would represent an increase of $8,071 over the $25,000 that you had paid, a return of 32.9%.
Tax Tip
Avoiding Early Withdrawal Penalties
If you make a Roth conversion, you must wait five years or until you reach age 59 1/2 before you can withdraw the converted amount free from the IRS’ 10% early withdrawal penalty. The clock for those five years starts on January 1 of the year that you make the conversion. You could make the conversion late in a year, meaning you would have to wait closer to four years before you can touch earnings without penalty.
Each conversion has its own five-year holding period. If an individual does one conversion in 2021 and a second conversion in 2022, the amount from the first conversion can be withdrawn penalty-free starting in 2026 and the amount from the second starting in 2027.
Earnings on a converted amount can be withdrawn tax- and penalty-free after the owner reaches age 59 1/2, as long as he or she has had any Roth IRA opened at least five years.
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