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December 20, 2023

Year-End Tax Planning: Roth Conversions

by Paxton Dolan

As we head full speed into the end of the year, there’s a lot to think about. Between visits with family and friends, holiday shopping, and celebrations, it can be hard to make time for anything else. There is, however, one important year-end process we highly encourage you to consider this time of year and that’s – you guessed it – year-end tax planning!

It is all too easy to put off worrying about taxes when the April 15th filing deadline feels so far away. But we at R&A know from experience that the ideal time to start thinking about your taxes is actually prior to year-end. This gives you the opportunity to make moves that can help to minimize your tax liability. In this article, we’ll be taking a closer look at one of these strategic tax planning opportunities: Roth conversions.

Roth Conversions

The 4 Ws of Roth Conversions

Before we get too far into the specifics, it’s important to start with a solid understanding of what a Roth conversion is, how it works, and why it may or may not be beneficial for you.

Roth conversions – What are they?

Essentially, a Roth conversion is the act of repositioning your IRA or other traditional retirement assets to a Roth IRA. This can be done in a few different ways.

First, you can take a cash distribution from your IRA deposit those funds into a Roth IRA. This is what is known as a 60-day rollover, meaning that the funds MUST be deposited into the Roth IRA within 60 days. If you do not deposit the funds within this timeframe and are under age 59 ½, you will be subject to a 10% penalty in addition to the regular income taxes on the amount withdrawn from the IRA.

You can also do what is known as a “trustee-to trustee” transfer directly from your IRA to your Roth IRA. This route can allow for less risk and potential for error when making the conversion, especially if both accounts are with the same institution.

Roth conversions – Why are they beneficial?

IRAs and other traditional retirement accounts are funded with pre-tax dollars, meaning that the initial contribution is tax-deductible. While this gives you the benefit of a break on your taxes in the year the contribution is made, you will be taxed on the gains in the account once you begin to withdraw them, typically at age 59 ½.

Additionally, traditional IRAs are subject to Required Minimum Distributions (RMDs), the IRS’s way of getting back some of that tax-deferred money, which has been growing in your account over a period of many years. Starting at age 73, you will be required to withdraw a certain amount from your account, and this withdrawal will be taxed at your regular rate. For those with large IRAs, this could be a real hit to your tax bill.

This is where a Roth conversion could potentially come in handy. Where traditional IRAs are funded with pre-tax dollars, Roth IRAs are funded with after-tax dollars. This means that you pay the taxes on the contribution up front, allowing the money to grow tax-free for as long as you have the account. Withdrawals from a Roth IRA will also be tax-free, provided you meet certain requirements. Roth IRAs also are not subject to RMDs, which means you can determine when and how much you withdraw per year in retirement.

There are certain rules in place regarding eligibility to contribute to a Roth IRA outright. Eligibility is determined by your modified adjusted gross income (MAGI). In 2023, your MAGI must be less than $138,000 as a single filer or less than $218,000 if you are married filing jointly in order to contribute the full amount to a Roth IRA. If your MAGI is over $153,000 as a single filer or $228,000 if you are married filing jointly, you are not eligible to contribute at all.

There are, however, no income restrictions on Roth conversions. This means that even if your income is over the limit to make a direct contribution, you are still able to convert assets from your traditional IRA to take advantage of the benefit of tax-free growth.

Roth conversions – Who should be doing them?

As I noted above, there are no income limits or restrictions on who is able to convert their IRA assets to Roth. That being said, there are certain situations where a Roth conversion may or may not be a good idea. How do you know which applies to you? Here are some questions you can ask yourself.

  • Do I think my tax bracket will be higher in future years and/or in retirement? If the answer to this question is yes, a Roth conversion might make sense for you. Because you will pay taxes on your initial contribution, it makes sense to pay them now, while your tax bracket is lower, than in the future, when you will be required to withdraw funds from your IRA.
  • Do I want to leave more money for my heirs? If you don’t have a need for the funds in your IRA, and plan to leave these to your heirs in the event something should happen to you, it might be a good idea to convert some of these assets to Roth. This means that when your heirs inherit the account and withdraw the funds, the withdrawals will be tax-free so long as the account is more than 5 years old.
  • How soon will I need the funds in my IRA? As I alluded to above, withdrawals of earnings from a Roth IRA will be taxed at your normal income rate if the funds are taken from the account while it is less than 5 years old. So, if you are retired or are nearing retirement and will need access to these funds sooner, a Roth conversion may not be the best option for you.

These are just a few examples of questions you may take into consideration when deciding whether to proceed with a Roth conversion. As always, we recommend working with a qualified tax preparer on your year-end tax planning to ensure that all aspects of your unique situation are accounted for before proceeding with any strategic year-end tax planning opportunities.

Roth conversions – When should you convert?

The technical answer to this question is anytime. There are no limits on the number of Roth conversions you can do in a year. That being said, as with the question above, the true answer is a bit more nuanced than that.

Because your initial contribution into the Roth IRA will be taxed at your normal income tax rate, you’ll want to make sure you do this at a time when you have funds available to pay the resulting tax bill. You may also want to evaluate your income and overall investment performance to determine if a Roth conversion makes sense.

Special note for business owners and the self-employed: In years when your income is lower than what is typical, a Roth conversion could be a smart move for you since this could have a lower impact on your overall tax burden for the year.

Year-end is a great time to look at the potential for Roth conversions. As the year is coming to a close, it is generally easier to estimate tax liability and determine the ideal amount to convert.

 

In Conclusion

Year-end tax planning is a complex process involving the consideration of multiple factors to determine which tax-smart moves may help to lower your overall tax liability. Roth conversions are just one example of these strategic opportunities that could really help with your long-term tax planning.

To learn more about year-end tax planning and which strategies may be a good fit for your unique financial situation, please feel free to contact us.

 

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