By ROB WILLIAMS
MAY 11, 2018
Does it ever make sense to pay taxes on retirement savings sooner rather than later? When it comes to a Roth Individual Retirement Account (IRA), the answer could be yes.
That’s because, although a Roth IRA is funded with after-tax dollars, qualified withdrawals are entirely tax-free.1 What’s more, Roth IRAs aren’t subject to the required minimum distributions (RMDs) the IRS mandates you take from most other retirement accounts once you reach age 70½, giving you greater control over your taxable income in retirement.
The hitch is that you can’t contribute to a Roth IRA in 2018 if your income equals or exceeds certain limits ($135,000 for single filers and $199,000 for married couples filing jointly). But there’s a workaround: A Roth IRA conversion allows anyone, regardless of income level, to convert existing IRA funds to a Roth IRA.
Should you convert to a Roth?
You must pay income taxes on any converted funds in the year of the conversion, but there are three scenarios in which that might be to your advantage:
1. You believe your tax bracket will be higher in retirement: In this scenario, paying taxes at your current tax rate is preferential to paying a higher rate after you’ve stopped working. This may sound far-fetched, but it isn’t particularly difficult to do, especially if you haven’t yet hit your peak earning years or you’ve accumulated significant savings in your retirement accounts.
2. You want to maximize your estate for your heirs: If you don’t need to tap your IRA funds during your lifetime, converting to a Roth allows your savings to grow undiminished by RMDs, potentially leaving more for your heirs-who will also benefit from tax-free withdrawals during their lifetimes.
That said, the decision to convert to a Roth IRA doesn’t have to be all or nothing. You may find dividing your savings among Roth and traditional IRA and/or a Roth and traditional 401(k) is the optimal solution.
How do you convert to a Roth IRA?
If you do decide a Roth IRA conversion is right for you, you’ll need to determine two things:
1. When to execute the conversion: If you have a significant balance in your traditional IRA, you may want to carry out multiple Roth IRA conversions over several years. For example, you might convert just enough to keep yourself from being catapulted into the next tax bracket. If done properly, a multiyear approach could allow you to convert a large portion of your savings to a Roth while limiting the tax impact. Early in retirement-when your earned income drops but before RMDs kick in-can be an especially good time to implement this strategy.
2. How you’ll pay the resulting tax bill: Ideally, you’d have cash on hand outside your IRA to pay the income tax on any converted funds—for several reasons:
- Any IRA money used to pay taxes won’t be accumulating gains tax-free for retirement, undermining the very purpose of a Roth IRA conversion.
- If you sell appreciated assets to pay the conversion tax, capital-gains taxes could further undermine the benefits of a conversion. Plus, if you’re under 591/2 and withdraw money from a tax-deferred account, you’ll incur a 10% federal penalty (state penalties may also apply).
In short, converting to a Roth IRA can give you the potential to cut your tax bill in retirement, but be sure to consult a qualified tax advisor and financial planner before making the move.
1 Qualified distributions are those that occur at least five years after the account is established. At least one of the following conditions must also be met: the account holder is 59½ or older at the time of withdrawal; the account holder is permanently disabled; distributed assets (up to $10,000) are used toward the purchase or rebuilding of a first home for the account holder or a qualified family member; or withdrawals are made by the account beneficiary after the holder’s death.
This information is not intended to be a substitute for specific individualized tax, legal or investment-planning advice. Where specific advice is necessary or appropriate, Schwab recommends that you consult with a qualified tax advisor, CPA, financial planner or investment manager.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
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