A popular tax planning strategy today is the Roth Conversion.
And it's no surprise why.
Roth IRAs offer tax-free withdrawals if the account has been open for 5 years and you are over age 59 1/2. Roth IRAs also let you invest in a variety of assets, like stocks and real estate, so you can take advantage of capital appreciation on your contributions to maximize the tax-free withdrawal benefit.
However, the IRS limits who can directly contribute to a Roth IRA based on income so not everyone may have a substantial amount in a Roth IRA or they may not have a Roth IRA at all.
So, how do you take advantage of the Roth IRA and its benefits if you were unable to accumulate substantial Roth IRA assets?
Enter the Roth Conversion strategy.
This strategy is completely legal and allows people with tax-deferred accounts, like IRAs and 401ks, to be able to convert those funds into Roth IRA money.
Why would you want to convert money from tax-deferred to tax-free?
Well, this is a loaded question and perhaps another day I will dive deeper into this, but the basic reason is because having Roth money will potentially lower your taxes paid over your lifetime AND the lifetime of the next generation (like your kids and grandkids).
Moreover, income tax rates are at historically low levels and, while this is complete speculation, tax rates can likely increase over the next years and decades.
For example, according to the Tax Policy Center, a nonpartisan tax think tank in Washington D.C., as recent as 1985 the top marginal tax rate was 50% and in 1975 the top marginal tax rate was 70%. Currently, the top marginal rate is 37%.
So, tax rates are lower than they have been over the past few decades and if tax rates are to increase then it would make sense to limit your tax expense as much as you legally can.
So how does the Roth Conversion work?
Essentially, you convert all or a portion of your IRA or 401k into a Roth IRA (your financial advisor can help facilitate this). You will owe taxes on whatever you convert and you can choose to pay the tax either out of your cash in your bank account or income, or you can pay it by having a portion of the conversion amount withheld for taxes.
For example, if you convert $10,000 out of your IRA into your Roth IRA and you want to withhold 10% for federal taxes and 5% for state taxes then you would withhold a total of $1,500 ($1,000 federal and $500 state) from your $10,000 conversion. Therefore, a total of $8,500 would go into your Roth IRA from the conversion.
Now since you owe tax on whatever is converted in a given year you need to mindful of taxes.
Most likely it will not make sense to convert the entire amount of your IRA, unless it is a relatively small account size.
Therefore, you will want to convert a portion of your IRA or 401k over time each year. You can randomly choose an amount to convert, but it is usually more wise to convert an amount every year that will "fill up" your current tax bracket. That way you convert the maximum amount you can without bumping yourself up into the next tax bracket.
Whatever you convert for the year will be reported for tax purposes on form 1099-R showing the distribution amount and having that amount coded as a conversion. Also, any tax withheld from the conversion should be shown on that form as well.
Now, once your money has been converted and it is in your Roth IRA it makes the most sense to invest that money as aggressively as possible so the assets grow as much as possible, and so you can take the most advantage you can of the tax-free withdrawals.
I have been helping many clients with this strategy and if you would like to see how the Roth Conversion can benefit you please feel free to reach out to me and I'd be happy to discuss your situation.
Cheers.