The previous Tax Report explored the optimal time for older individuals to switch their taxable traditional IRAs to tax-exempt Roth IRAs. This sparked numerous queries from Journal readers seeking further details, which we will now tackle.
Why might it be sensible to execute a Roth IRA conversion even though this involves paying taxes earlier than required and reducing your initial investment size? I was typically advised to postpone tax payments for as long as feasible.
Roth IRA conversions aren’t appropriate for all savers. But they often make sense for people with large traditional IRAs, which many have due to rollovers of traditional 401(k)s.
The main element revolves around comparing the tax rate applied during the Roth IRA conversion with the one applicable at the time of withdrawal—a concept known as tax arbitrage. Typically, converting becomes a prudent choice when the tax rate at the point of conversion is expected to be lower than what it would be upon withdrawal.
What about “opportunity cost,” the idea that dollars used to pay conversion tax lose out on investment growth? This isn’t an issue if tax rates are the same at contribution and withdrawal. While the conversion tax is paid earlier, it’s also smaller—and the deferred tax on the traditional IRA grows as the funds do.
Ed Slott, a Roth IRA advocate and CPA, offers a simplified example: Jane and Fred each have traditional IRAs with $100,000. These are invested identically and double over 10 years. The tax rate is 30%, so Jane pays $30,000 of tax to convert to a Roth IRA and has $70,000 to invest. At the end, she has $140,000 to withdraw tax-free.
Meanwhile, Fred doesn’t do a conversion, and his $100,000 pot grows to $200,000. But when he withdraws it, he owes $60,000 of tax. That leaves him with $140,000 after tax, the same as Jane.
The wisdom of converting to a Roth IRA hinges on whether tax rates fluctuate over time. If Jane faces a 20% tax rate during the conversion process but expects a 30% rate when withdrawing funds later, she stands to benefit from the conversion. Conversely, if Fred encounters a 30% tax rate for the conversion yet anticipates only a 15% rate upon withdrawals, then such a conversion would be less advantageous for him.
Certainly, assessing a Roth conversion requires individuals to predict the future. However, this isn’t always challenging—for instance, when someone plans to relocate from a high-tax state to one with lower or no taxes. Additionally, the loss of a spouse may result in what is known as a "widow’s penalty," leading the surviving individual to face a higher maximum tax rate as a singlefiler.
However, individuals utilizing external funds to cover the conversion tax so as to retain additional dollars within their Roth IRA must evaluate where those funds originate. Should these taxes come from a low-interest account, it might make sense to use them for payment. Yet, if liquidating stocks would result in facing a 15% capital gain tax, further consideration is necessary. Might off-setting this with the sale of an asset experiencing losses be a viable strategy instead?
Investment performance is equally important, but this aspect requires even more estimation. The higher the potential earnings, the clearer the benefits of using a Roth IRA become. Typically, those who bet on assets increasing over time tend to fare much better compared to those predicting declines.
Can I transfer my inherited traditional IRA into a Roth IRA?
You can, if you are the surviving spouse of the owner. This involves rolling funds from the inherited IRA into an IRA of your own and then doing a Roth conversion.
However, many other beneficiaries of conventional IRAs aren't allowed to perform these conversions. Regardless of whether it's a traditional or a Roth IRA, most successors typically have to empty the accounts within ten years following the account holder's passing.
What impact does the five-year rule have on withdrawing funds from my Roth IRA?
A five-year waiting period exists for tax-free withdrawals from Roth IRAs, which often puzzles individuals considering such conversions. In fact, there are two separate five-year rules; however, just one of them pertains to those aged 59½ and above. Fortunately, most senior IRA holders typically do not encounter difficulties with this rule. Below is an overview.
If a saver aged 59 ½ or over has had at least one Roth IRA open for five years or longer, they do not have to wait an additional five years for tax-free withdrawals following a conversion.
If someone aged 59 ½ or older does not have a Roth IRA yet and decides to convert money from their traditional IRA, the rules differ slightly. During the initial five-year period following the conversion, this individual may withdraw the transferred sum without paying taxes; however, gains earned within those funds remain subject to taxation until after these five years pass. Should an early withdrawal be made during this time frame involving earnings, it would incur income tax liability—though importantly, such action wouldn’t attract the usual additional 10% penalty typically applied to individuals under age 59 ½.
If someone who is at least 59 ½ performs a Roth conversion under the five-year rule and passes away after three years, their beneficiaries can enjoy completely tax-free distributions within two additional years. In this period, conversions themselves won’t incur taxes; however, earnings withdrawn before the end of these two years will be taxed. As usual, there is no 10% early withdrawal penalty involved.
For individuals saving through Roth conversions, the withdrawal guidelines are advantageous as these withdrawals treat the transferred sums as being removed prior to the earnings. Once the entire converted sum has been taken out, subsequent distributions are then regarded as earnings, which may or may not be subject to taxation.
I am unmarried and plan to leave all my traditional IRAs to charitable organizations. Should I consider converting them into Roth IRAs?
No, you shouldn't do that. Transferring traditional IRAs to charities offers a triple tax advantage: there's no tax on funds being deposited, no tax on the earnings, and no tax when those dollars are gifted to the charity.
Transferring part or all of your traditional IRA to a Roth IRA involves paying taxes at a time when it might not be necessary, which could reduce the funds available for charitable donations.
I'm conducting partial Roth conversions and aiming to dodge increased Medicare surcharges, but we're uncertain about future income thresholds. Any suggestions on how to proceed?
A lot of individuals saving money encounter this issue when considering Roth IRA conversions due to the additional charges imposed by Medicare Part B and D for high-income earners, referred to as Irmaa.
Thorough planning is crucial since an additional dollar of income can result in significantly higher Irmaa surcharges. This becomes particularly complex as these surcharges are calculated using income data from two years earlier. Therefore, the Irmaa surcharges scheduled for announcement in 2025 will be based on the income reported in 2023 and will factor in any income generated from Roth conversions conducted during that period.
Certain individuals aiming to dodge increased Medicare premiums due to IRMAA utilize the latest published IRMAA brackets for an added buffer. Conversely, some turn to resources like The Finance Buff, which predicts potential future IRMAA surcharges using accessible yet not fully comprehensive information.
Send an email to Laura Saunders at Laura.Saunders@wsj.com
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