Executive Vice President, Portfolio and Wealth Management
Introduction to Roth IRAs
Roth IRAs are after-tax retirement accounts. While not tax deductible when they are funded, they grow tax free and withdrawals are income tax free provided they are withdrawn after age 59 ½. Additionally, most Roth IRAs are not subject to required minimum distributions. Roth IRAs have been available since 1997 and individuals can convert their traditional (pre-tax) IRAs to Roth IRAs by paying income tax on the balance converted. Individuals who exceed certain levels of income are not able to contribute to Roth IRAs. However, the income limit for converting traditional IRAs to Roth IRAs was eliminated in 2010 and this has opened another planning strategy for consideration by high-income earners.
Creating Your Own “Stretch IRA”
With the passage of the SECURE Act in December of 2019, most nonspouse beneficiaries of inherited individual retirement accounts (traditional and Roth IRAs) will need to withdraw 100 percent of the inherited IRA balance within 10 years following the death of the original IRA owner.* Under the previous law, beneficiaries could generally withdraw the balance over the course of their lifetimes and this was known as the “stretch IRA.” The potentially condensed timeframe of 10 years to complete distributions could force high levels of taxable income to the beneficiaries and push them into a higher tax bracket. One possible solution is for the IRA owner to convert part of all their traditional IRA to a Roth IRA. If an IRA owner did partial conversions for the 10 years prior to their death, this could stretch the taxation of the distributions out over 20 years (10 years prior to and 10 year after death) and possibly lower taxes.
Roth Conversion Considerations
There are a number of items to consider and assumptions to be made and therefore no perfect formula for deciding if a Roth conversion is appropriate for you. It will be important to consider the following factors and discuss the pros and cons with your tax and legal advisors. Ferguson Wellman and West Bearing have powerful modeling tools to support the analysis, but the assumptions will drive the outcome and your strategy should be determined in consultation with your entire team of professional advisors.
Converting your pre-tax retirement funds into a Roth account will trigger income tax now, but allow you and your beneficiaries to withdraw the funds free of income tax in the future.
Higher income in the near term may result in a higher income tax brackets, higher Medicare premiums and increased taxation of Social Security benefits.
Converting when values are relatively low will trigger less taxation and may be a smart move if you are not using funds from the IRA to pay the taxes.
With the SECURE Act limiting most inherited IRA distribution periods to 10 years, Roth IRAs are becoming even more attractive for transferring wealth. While beneficiaries must still withdraw Roth IRA balances within 10 years, the distributions will be tax free.
Electing to convert small portions of your IRA to a Roth IRA over many years may be a useful strategy for creating your own “stretch” IRA. The primary goal of this strategy is to limit the taxable income to a beneficiary in any given year.
Income tax rates: Several of the considerations listed above are driven by the goal of reducing the income tax rate that will apply to distributions. Income tax rates will be affected by three important factors:
o Size of the distribution
o Income tax rates of current owner versus future beneficiaries
o Possible changes in federal and state income tax rates
Estate taxes: For those who will be subject to estate tax**, Roth conversions prior to death will reduce estate taxes by virtue of the income tax being paid prior to estate taxes being calculated and thus the estate taxes are assessed on a smaller asset base.
Portfolio rates of return: The higher the assumed rate of return, the more likely the conversion will appear advantageous. This is because tax will be assessed on a relatively smaller number. However, assumptions are not reality and more realistic assumptions will lead to more informed decision making.
Length of time after conversion: All other things being equal, conversions are most beneficial when the funds remain invested in the Roth IRA for extended periods of time.
Source of funds to pay the taxes triggered by conversion: It is rarely advantageous to convert to a Roth IRA if you need to withdraw funds from the IRA to pay the taxes. Withdrawals to pay the taxes on conversion will be subject to taxation and possible penalty.
Charitable intent: Naming a charity as beneficiary of a traditional IRA is not only impactful, but also is tax-wise as the charity will not be subject to any income or estate taxes. However, it would not make sense to convert a traditional IRA to a Roth IRA if funds are going to charity.
Five-year period: In general, taxes will be assessed on the earnings of converted funds that are withdrawn within five years and a 10 percent penalty will likely apply to the withdrawal.
Ferguson Wellman and West Bearing do not provide tax or legal advice. This material has been prepared for general educational and informational purposes only and not as a substitute for qualified counsel. You should consult qualified professionals to understand how this information may, or may not, apply specifically to you.
* If the original IRA owner died on or after January 1, 2020.
**Currently, the federal estate tax rate is 40 percent on assets over $11.58 million, the Oregon estate tax rate is 10-to-16 percent on assets over $1 million and Washington is a 10-to-20 percent tax on assets over $2.193 million. Idaho and California do not currently have a state level, estate tax, but residents are still subject to federal estate taxes. Both federal and state level estate taxes are subject to change and could result in negative outcomes.