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Roth Conversions

October 03, 2023

          Here we are in the last quarter of the year, already. Time to start thinking about end of the year planning opportunities. One thing on my mind, when talking with clients, is a Roth IRA Conversion. But does it make sense for you? 

          A Roth IRA Conversion is a transaction that converts your pretax IRA, 401k or 403b to tax-free Roth IRA. However, there is a catch. When you do the conversion, you have to recognize the amount of the conversion as taxable income in the year it's converted. Having said that, it might still make sense in certain circumstances. Here are a few examples...

  1. If the value of your IRA investments dropped you could do a full or partial Roth IRA conversion and get away with only paying tax on the lower value of those assets now, hoping they eventually rebound (tax free inside the Roth IRA). 
  2. Let's say you haven't had much income in 2023. Then the tax liability on a Roth Conversion may be inconsequential or possibly not even an issue. 
  3. Under the SECURE ACT, they changed the rules on inherited IRA's. Your beneficiaries now have to fully liquidate and pay tax on IRA's they inherit, within 10 years. If you're able to initiate annual partial Roth IRA conversions, with little tax consequence or a lower tax than your beneficiaries would pay, you may be setting them up for a tax-free Roth IRA that they could defer up to 10 more years and liquidate completely tax free. 
  4. Let's say you just sold your home and plan to use the money to live on and travel the world. Since it's after tax, you wouldn't have any taxable income (assuming you have no other source of income, like a pension). Married couples, in 2023, have a $27,700 standard deduction, meaning the first $27,700 of income is tax free. So, in that case, if you have after tax resources to live on, you could do partial Roth IRA conversions up to the standard deduction allowance and not pay any tax on the conversion! This could set yourself up for a future tax-free income source as well. 

          These are just a few examples of how a Roth IRA Conversion might make sense. But just be aware of these obstacles***....

  1. Conversions carry a 5-year waiting period before the Roth IRA is considered tax free. So be sure to save your 8606 tax forms showing when each conversion took place. 
  2. If you convert from an IRA to a Roth under the age of 59 1/2 it's not advisable to have the taxes withheld from the conversion, because that amount would be treated as a premature distribution, subject to a 10% penalty on top of the taxes owed. 
  3. If you do convert assets that have lost significant value and those investments drop further, or even go bust, you paid tax on money you never even have any longer. 
  4. Since a conversion is fully taxable, you need to understand that it could trigger additional tax on your Social Security Benefits, possibly making the conversion more expensive than previously thought. 

          Just like any financial planning strategy, some ideas are great for some people and not so great for others. But understanding the power of a Roth IRA Conversion and knowing when to implement the strategy is key. If you would like to discuss the possibility of a Roth IRA Conversion before the end of the year, give us a call!