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Lisa Borrelli (WSFS): How can Roth Conversions help investors?

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By Lisa M. Borrelli, CPA
When getting close to the age required for minimum distributions from retirement accounts, many investors may benefit from a Roth conversion. A Roth conversion is the process of taking funds from a Traditional/Rollover Individual Retirement Account (IRA) and “converting” such funds to a Roth IRA.  Depending on an investor’s tax bracket, a Roth conversion may allow investors to recognize significant tax savings. Unlike other retirement accounts, Roth IRAs do not require the distribution of funds during the lifetime of the account owner—providing additional planning flexibility.

Early Roth conversions may be a particularly good idea this year because of reduced asset values due to the recent market downturn. The changes brought about by the SECURE Act of 2019 have shown Roth conversions to be an even more valuable tool now that next generation beneficiaries have a reduced time frame during to make withdrawals.

Beneficiaries of Inherited IRAs (both Traditional and Roth) must take the full account value as distributions within a 10-year period, so preexisting stretch provisions in Inherited IRAs have essentially been eliminated. Change brings opportunities and there’s an underlying benefit to start implementing goals ahead of the curve to pave the way to a more secure financial future.

Retirement Plans Requiring Distributions

After decades of hard work, some investors find themselves retiring with significant assets in qualified accounts, like an IRA, 401(k) or 403(b). These accounts are excellent savings tools because contributions are generally made pre-tax, with taxable income from growth within the account deferred until withdrawn. Because the contributions were not taxed when contributed, the investor pays ordinary income tax upon withdrawal. The IRS requires investors take distributions from these qualified retirement accounts each year after they reach age 72.  These distributions are called “Required Minimum Distributions” (RMD’s) and are calculated pursuant to a specific equation set forth by the IRS. As the investor ages, a greater percentage of the account value is required to be distributed. Depending on the size of the account, RMD’s can be large enough to significantly increase an investor’s tax rate.

Individuals born on or before June 30, 1949, will continue taking RMDs under the old rule. When taking an RMD related to IRAs, an investor may calculate the total RMD from all IRAs and take the distribution from a single account.  When taking an RMD from a 401(k) or similar plan, each specific plan account must take a separate distribution.

Roth IRA Plans

Roth IRA assets are not subject to taxes on growth and/or income while in the account. Unlike the IRAs, there are no RMDs from the account during the owner’s lifetime.  The investor is not taxed on distributions from the account.

Because of the benefits, contributions to a Roth IRA account are limited. The maximum contribution to both traditional and Roth IRAs in 2020 is $6,000 ($7,000 for investors over 50). For Roth IRAs, this contribution amount is phased-out when a single-filling investor’s adjusted gross income (AGI) reaches $124,000; eligibility is eliminated completely when AGI exceeds $139,000.  If investors are Married Filing Jointly taxpayers, the phase-out occurs for AGI between $196,000 and $206,000.  While this precludes direct contributions at these income levels, the IRS accepts what is typically referred to as “back-door” Roth IRA contributions by making a non-deductible contribution to a Traditional IRA then immediately converting to a Roth IRA during the same tax year. This strategy can allow investors across all income levels to utilize Roth IRAs.

Roth Conversion

The IRS allows investors to add additional funds to a Roth IRA through a strategy called Roth conversion. With this strategy, investors can “convert” retirement funds from an IRA to a Roth account regardless of the investor’s income level. The conversion is done by taking a distribution from the IRA account, paying tax at the investor’s current ordinary income tax rate,  and then placing the funds into a Roth account.

A conversion is generally beneficial when investors find themselves in (or anticipate) a relatively lower tax bracket with the expectation it will increase long term. The strategy creates tax savings by pulling income to the current lower rate from the potentially higher future rate—the larger the gap between current and future tax rates and the longer the duration of the difference, the more beneficial the strategy. Roth conversions also lower the value of assets held in the IRA account, thereby lowering the future RMD amounts.

The Roth conversion strategy may offer a tax savings to certain investors. However, it is not recommended for all investors. A successful Roth conversion strategy depends critically on tax rates and investors should confirm all figures with a tax advisor prior to undertaking a conversion.

Lisa Borrelli is a wealth planner at West Capital Management, a subsidiary of Wilmington-based WSFS Financial Corp. She works with clients on planning areas including income tax and liability exposure, business planning, and trust and estate planning.

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