Roth IRA Conversions: A Fresh Perspective

Transcription

1 Roth IRA Conversions: A Fresh Perspective Roth individual retirement accounts (IRAs) have provided investors with a tax-efficient way to save for retirement as well as lessen their income tax burden and transfer assets to beneficiaries after retirement. These benefits can have a positive impact; however, in order to receive the benefits of a Roth IRA, investors must be prepared to pay additional income taxes in the year of conversion. Most struggle with whether it is better to convert the account now and pay the taxes upfront, or not convert and defer paying taxes on a potentially higher amount at a later date. Fortunately, it is not an all-or-none decision. A middle ground can be achieved through partial conversions. Have investment questions? Contact a Texas Capital Bank Private Wealth Advisor at Texas Capital Bank, N.A.

2 Roth IRA Basics A tax-efficient way to save for retirement and limit taxes in retirement. As you plan for retirement, a Roth IRA may be an appealing retirement fund option since it allows you and your beneficiary to receive tax-free growth on your qualified distributions and allows the owner to avoid required minimum distributions (RMDs). You can fund a Roth IRA through a contribution, a rollover from an employer retirement plan or a conversion from an IRA, known as a Roth conversion. BENEFITS OF A ROTH IRA Qualified conversions receive tax-free growth and distributions. No required minimum distributions after 70½ years of age means longer deferral periods for owners and spouses. Qualified distributions are not included in adjusted gross income (AGI), which could potentially minimize your tax burden in retirement by avoiding or minimizing net investment income tax, Social Security tax and Medicare costs, while increasing your access to itemized deductions. Tax diversification allows for better tax management because it enables taxpayers to choose the most taxefficient account or investment from which to withdraw. The amount you pay in taxes to convert could serve as a gift to beneficiaries without using your gift/estate tax exemption and it could reduce the value of your estate for tax purposes. Taxpayers can reverse the Roth conversion if they change their mind about paying the income taxes or if the investments decline in value. The typical deadline is October 15 (April 15 including all extensions) of the following year after the conversion. NOTE: Individuals must be at least 59½ years old and have held the account for five years in order to realize the benefit of tax-free, penalty-free earnings and withdrawals. The deadline for making a conversion is December 31 of the current year. Please note, changes in tax laws may occur at any time and could have a substantial impact upon each person s situation. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. Like Traditional IRAs, contribution limits apply to Roth IRAs. In addition, with a Roth IRA, your allowable contribution may be reduced or eliminated if your annual income exceeds certain limits. Contributions to a Roth IRA are never tax deductible, but if certain conditions are met, distributions will be completely income tax free. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications. Investors should consult a tax advisor before deciding to do a conversion.

3 Considering a Roth IRA Conversion? Discuss these questions with your financial planner to determine if it s the right strategy for you. YES NO YES NO Do you or your beneficiary expect to be in the same or higher marginal tax bracket in the future? Do you anticipate not needing the money in retirement? Do you have a lengthy time horizon for the investments in the account to grow? Do you have additional assets outside of your IRA to meet living expenses in retirement? Do you plan to name a trust as the beneficiary of the IRA for the benefit of your children or grandchildren? Do you have after-tax contributions in an employer retirement plan? Do you have tax deductions such as charitable carry forwards, net operating losses, high medical expenses, credits, etc., that could offset the conversion income? Do you expect to be in a much lower marginal tax bracket in the future? Do you need to begin taking distributions from the account immediately? Do you plan to utilize the Qualified Charitable Distribution rules at 70½? Do you plan to donate the assets in the IRA to charity at your death? Do you need to use the money that would otherwise be used to pay taxes on the conversion? Do you plan to pay the taxes on the conversion by making a withdrawal from the IRA account? Do you feel comfortable paying taxes in the current tax year to gain tax-free earnings in retirement? Do you have enough liquidity from taxable accounts (non-ira accounts) to pay the taxes on the conversion? If your response to one or more of the questions above is yes, a Roth IRA conversion may be right for you. If your response to one or more of the questions above is yes, a Roth IRA conversion may not be right for you right now. Member FDIC NASDAQ : TCBI 3

4 The Best of Both Worlds Realize the tax beneſits of a Roth IRA without the heavy tax burden with a partial conversion or a series of partial conversions. If a Roth IRA conversion is right for you, but you re overwhelmed by the thought of a larger tax bill, a partial Roth IRA conversion may be the solution. Partial conversions allow you to hedge the unknown and still realize the tax benefits of a Roth IRA, giving you the flexibility to choose how much to convert so you can be strategic about how a conversion affects your tax bracket and your tax bill for the current year. You can also plan a series of conversions using the same strategy to convert a significant percentage, if not all, of a traditional IRA into a Roth IRA over a short or long period of time. A series of partial conversions can act as a pay-as-you-go plan, allowing you to assess your financial situation each year before making a conversion. In future years, you may decide against partial conversions and transfer the tax burden to another person or time when it may be more beneficial to execute a conversion. Member FDIC NASDAQ : TCBI 4

5 Weighing the Options Meet Brett. He and his wife, Linda, are both 55 years old. They are in the top tax bracket and plan to be throughout retirement. They expect a 6% annual investment growth rate. Brett currently has a $500,000 traditional IRA to which they do not plan to make future contributions. Brett and Linda are weighing their options on what to do with the IRA. This is a hypothetical example for illustration purpose only. Member FDIC NASDAQ : TCBI 5

6 Weighing the Options Their first option is to do nothing Option 1 at all just let the IRA be. If they don t convert the IRA, it Let It Be could grow to $1.2 million by the time they re 70½ years old. At that point, they would be required to start taking minimum distributions, which would be taxed at the then current tax rate*. The account will be distributed based on life expectancy tables and the withdrawal percentage would increase each year until the account is totally depleted, or the balance would transfer to the beneficiary at Brett s passing. BENEFITS Brett can avoid upfront taxes on conversion. DRAWBACKS Required minimum distributions (RMDs) start at 70½ years of age, whether Brett needs the income or not. These distributions reduce the amount of principal eligible for growth, and the potential for growth will continue to decrease over time. *The tax rate could potentially rise or fall in the future. This is a hypothetical example for illustration purpose only. Member FDIC NASDAQ : TCBI 6

7 Weighing the Options Their second option is to convert Option 2 the entire $500,000 traditional IRA to a Roth IRA. They would Fully Convert to a Roth pay taxes on $500,000 based on the 39.6% marginal rate*. The approximate upfront tax paid will be $200,000. The investments could grow to $1.2 million by the time they re 70½ years old, but they wouldn t need to pay any additional tax on that growth. In addition, since RMDs are not required, the accounts could continue to grow tax-free. So if the account grew for 10 additional years with no distributions, at 80½ years of age, the account would be worth $2.15 million and distributions would not be subject to tax. BENEFITS Principal and interest will grow tax-free; no taxes need to be paid on withdrawals. If Brett and Linda do not take any withdrawals, principal and interest can continue to grow since no RMDs are required. DRAWBACKS Brett must pay tax on the conversion amount for the year of conversion. *The tax rate could potentially rise or fall in the future. This is a hypothetical example for illustration purpose only. Member FDIC NASDAQ : TCBI 7

8 Weighing the Options Option 3 A Series of Partial Conversions If they made a partial conversion of $100,000 now, they would pay taxes based on the amount converted at the 39.6% marginal rate or approximately $40,000. The investments would grow to $1.2 million by age 70½. The $100,000 conversion amount would grow tax-free to $240,000, which is 11% of the $1.2 million. If they made the same partial conversion in a series over the next several years, the result could be a significant percentage of the IRA, if not all, converted to a Roth. BENEFITS The conversion amount would grow and be eligible for taxfree withdrawal. Brett has the ability to execute the same strategy in future years and adjust strategy as needed. DRAWBACKS Taxes are paid up front at the time of conversion; however, would not be as high as in option 2. *The tax rate could potentially rise or fall in the future. This is a hypothetical example for illustration purpose only. Member FDIC NASDAQ : TCBI 8

9 We Can Help Converting a traditional IRA or employer retirement plan to a Roth IRA requires you to pay tax on the conversion amount in the year of conversion, which can result in an unusually high tax bill, a distribution taxed at a higher rate or possibly both. The decision to convert to a Roth IRA can be a difficult one to make since a burdensome tax bill may override the potential benefits. Furthermore, many of the financial factors used to determine the best timing for a conversion are unknown (future tax rates, withdrawal rates, investment returns) and can be hard to measure. Talking through the options with an advisor can help you make the decision. Contact a Private Wealth Advisor at to develop your personalized retirement plan and determine if this strategy is right for you McKinney Ave. Suite 1800 Dallas, TX One Riverway Suite 2100 Houston, TX San Jacinto Blvd. Suite 200 Austin, TX East Mulberry Suite 350 San Antonio, TX Throckmorton Suite 200 Fort Worth, TX Disclaimer: Neither Texas Capital Bank, N.A. nor any of its employees provide tax or legal advice to outside entities. Nothing contained in this communication (including any attachments) is intended as tax or legal advice for any recipient, nor should it be relied on as such. Taxpayers should seek advice based on the taxpayer s particular circumstances from an independent tax advisor or legal counsel. The wealth strategy team at Texas Capital Bank can work with your attorney to facilitate the desired structure of your estate plan. Securities offered through Raymond James Financial Services, Inc. Member FINRA/SIPC, and are not insured by bank insurance, the FDIC or any other government agency, are not deposits or obligations of the bank, are not guaranteed by the bank, and are subject to risks, including the possible loss of principal. Investment advisory services offered through Raymond James Financial Services Advisors, Inc. Texas Capital Bank Private Wealth Advisors and Texas Capital Bank are not registered broker/dealers and are independent of Raymond James Financial Services, Inc.The information contained in this communication is not a complete summary or statement of all available data necessary for making an investment decision, and does not constitute a recommendation. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of authors and not necessarily those of RJFS or Raymond James. Raymond James and its advisors do not offer tax advice. You should discuss any tax matters with the appropriate professional. Member FDIC NASDAQ : TCBI 9