Why Tax Law Changes May Spur Roth IRA Conversions
At PENSCO, we've had retirement investors inquire about converting Traditional IRAs to Roth IRAs to avoid having to take required minimum distributions once they hit the age of 70.5. In 2018, there may be a new reason retirement savers decide to opt for a Roth conversion—tax law changes. That's because the Tax Cuts and Jobs Act of 2017 reduced individual income tax rates, meaning it may cost less for investors to convert their retirement funds to a Roth IRA this year.
Traditional IRAs, Roth IRAs and Tax Implications
In a Traditional IRA, your contribution may be fully or partial tax deductible; therefore, you may not have to pay taxes when you put money into your IRA. But owners of Traditional IRAs must start taking yearly required minimum distributions (RMDs) once they turn 70.5. Those withdrawals are taxed as ordinary income.
Required minimum distribution rules do not apply to Roth IRA accounts while the holder is alive. With a Roth IRA, contributions are made with after-tax dollars, so your retirement funds may be withdrawn tax-free. This can be beneficial for investors who experience a significant return on their investment..
Investors have long been able to convert Traditional IRAs to Roth IRAs. When Traditional IRA dollars are converted to a Roth IRA, those traditional pretax funds may be added in your income for the year and subject to taxation. Depending on how large those funds are, they could bump you into a higher tax bracket and result in a larger tax bill.
According to Money, the 2017 tax law lowered the top individual income tax rate to 37% from 39.6%, and reduced many other rates. If you convert your Traditional IRA to a Roth and pay taxes on those funds now, you will be paying at a lower rate than before, potentially making a Roth conversion more attractive. Given that individual tax cuts are set to expire in 2025, investors may seriously consider making conversions now, while tax rates remain low.
Is a Roth Conversion Right For You?
Roth conversions are not for every retirement saver. Here are two circumstances where converting from a Traditional to a Roth IRA could hurt you:
- You don’t have funds to pay the upfront tax liability. If you have to use funds from your retirement accounts to pay the tax liability, any benefit you would get from a conversion could be far less or even non-existent. That’s because of the opportunity cost in terms of missed investment returns of withdrawing funds from your retirement account.
- A conversion would push you into a much higher tax bracket. The goal in converting a Traditional IRA to a Roth is to save taxes over the long-term. The tax hit you take upfront should be offset by the opportunity for your funds to grow tax-free and be withdrawn without being subject to taxation later. But if the amount of taxes due on conversion is significant enough, any long-term savings could be a wash or offset enough to leave you worse off since that’s money that isn’t available to grow in your retirement account.
Beware: A Roth Conversion is Now Final
In the past, retirement savers could convert to a Roth IRA. Then, if they changed their minds, they could re-characterize their Roth conversion back to a Traditional IRA by Oct. 15 of the following year. But under the new tax law, going forward a contribution in a Roth is still eligible to be re-characterized but a conversion back to a Traditional is no longer an option. If you decide to convert your IRA, you will not be able to reverse that decision.
Also, be sure you are familiar with the 5-year rule for Roth conversions. According to the Slott Report, if you are under age 59 ½ and take a distribution within five years of your conversion, your distribution will be subject to the 10% early distribution penalty on the gains, unless an exception—such as disability—applies. For example, if you convert funds from your Traditional IRA for $100k, then do a distribution of $90k prior to turning 59 1/2 and fulfilling the 5 year rule, you would not be subject to taxes because the distribution taken is part of your cost basis. You would, however, be subject to penalties. The five year rule is applicable for those over 59 1/2 as well. If you are over 59 1/2 and take a distribution prior to the 5 year rule, you are still subject to the 10% on the gains. You can refer to IRS Publication 590-B for more details.
If you are considering a Roth conversion, a tax or financial professional can walk you through pros and cons, and help you decide if a Roth IRA conversion is in your best interest. If you have questions about a PENSCO Traditional IRA or Roth IRA, you can reach us at 800.962.4238.
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Pacific Premier Trust (formerly PENSCO Trust Company) performs the duties of an independent custodian of assets for self-directed individual and business retirement accounts and does not provide investment advice, sell investments or offer any tax or legal advice. Clients or potential clients are advised to perform their own due diligence in choosing any investment opportunity as well as selecting any professional to assist them with an investment opportunity. Alternative investments are not FDIC insured and are subject to risk, including loss of principal. Pacific Premier Trust is not affiliated with any financial professional, investment, investment sponsor, or investment, tax or legal advisor.