by Craig Pellet, CPA
Certain taxpayers can save on taxes in retirement by moving assets into a Roth IRA from another type of retirement account. However, the strategy may not be right for everyone, as you can incur a big tax bill if a conversion is done carelessly. Also, opportunities for upper-income folks to convert other retirement accounts to Roth-IRAs could end sometime in the next few years. Here are some pointers to help you determine if a Roth IRA is right for you.
Consider a Roth conversion if your deduction for traditional IRA contributions is disallowed
If you are not allowed to deduct contributions to a traditional IRA because of income limitations, you could benefit from a Roth conversion. Whether traditional IRA contributions are deductible or not depends on your filing status, as well as whether you are covered by a retirement plan at work. If you are single and have a retirement plan at work, your deduction begins to go away when your income is over $61,000. For married individuals full traditional IRA deductions are allowed up to $98,000.
When you convert a traditional IRA to a Roth, you pay tax. But not on nondeductible contributions coming back to you. You just owe tax on growth in the account, plus any deductible money. So if you make a nondeductible contribution, and promptly convert that contribution by moving it into a Roth IRA, you are likely to pay no tax, as there will have been no time for growth in the original traditional IRA.
Here’s an example of how that strategy works, step-by-step:
- First, make a nondeductible contribution to your traditional IRA. You can make a 2016 contribution as late as April 17, 2017. Because you receive no deduction for the contributions, your IRA now has basis in the amount of your contribution.
- Immediately after, convert the contributed amount to a Roth IRA. The transfer is tax-free, because your traditional IRA has basis to cover the amount that you transferred to a Roth IRA.
But be careful if you have other assets in IRAs
Let’s say you make a nondeductible contribution of $5,000 to a traditional IRA. But you have already made deductible contributions to that same IRA, or to some other non-Roth IRA, including traditional, SIMPLE and SEP IRAs. Can you convert that $5,000 to a Roth-IRA tax free?
Nope. When determining how much of a conversion is taxable, you consider the proportion of ALL your IRAs that consists of nondeductible contributions.
Here’s an example. Let’s say you rolled $95,000 from a 401k into a traditional IRA. Then you make a $5,000 nondeductible traditional IRA contribution. Now you want to roll $5,000 into a Roth IRA. 5% of your IRA has basis from the nondeductible contribution, so 5% of your rollover is tax-free. Only 5%! That adds $4,950 of income to your returns in the year of the rollover. This would remain true even if the original rollover from the 401k and the nondeductible contribution were made into different IRAs.
Consider rolling assets back into 401ks
You can avoid a taxable Roth conversion by rolling your traditional, SIMPLE and SEP IRAs into your current 401k. There is a lot to consider here, especially if your 401k plan is fee-heavy. But 401ks are not counted in determining your basis in IRAs pre-conversion.
If you can’t do a tax-free Roth conversion, consider it anyway
Generally, Roth IRAs are beneficial if you expect to be in a lower tax bracket in your working years, and a higher one in retirement. This could happen if, for example, you expect to inherit large sums in the coming years.
If your income is modest, consider contributing directly to a Roth
Roth contributions are disallowed above certain income levels, so if your income is low, you might consider making a direct contribution. It is generally beneficial to forego the deduction at a low tax rate in favor of tax-free growth.
Roth contributions are allowed if you income remains below $117,000 for single filers, and $184,000 for married couples.
If your employer offers a retirement plan, you should generally still prioritize contributions to that plan first. Most employers offer matching incentives that you will miss out on if you don’t make elective deferrals.
These conversion rules may go away
Currently, any taxpayer, no matter his or her income, can make a Roth conversion. However, earlier this year the Obama administration proposed disallowing them. It is a plausible proposal, as limits on conversions existed in 2009 and earlier years. Consider taking advantage of this strategy while you can!
At John Schachter + Associates, we help our clients make the most of Roth IRA conversions. Talk to us. Let us know how we can help you.