"Mary" gave me a call last week. She had read a blog article I had written back in July of last year on Roth IRA conversions.
She had been reading about this potential tax savings strategy for a while and wondered if it made sense for her.
First, a quick primer on the difference between a Roth IRA and a Traditional IRA.
Basically speaking, there are two different types of IRA's one can contribute to. A "Regular" or "Traditional" IRA and a "Roth" IRA.
The main difference is the Roth IRA contributions go in post-tax (you do not receive a tax deduction as you already paid taxes on this money) and if the rules are met, this money can come out tax free.
Unlike in a traditional or regular IRA, where the money is taxable upon withdrawal.
So, the appeal of the Roth IRA is tax free income in retirement. The other key difference is the Roth IRA owner does not have to take Required Minimum Distributions (RMD's) at any age.
One major hurdle in doing a Roth Conversion is you need to pay the taxes now on the amount converted.
The amount converted gets added to your income for that year so for example, if your income was 95k and you convert 50k, your taxable income that year is based on 145k.
(Therefore, it is important to keep an eye on tax brackets to help minimize jumping into the next higher tax bracket when doing these conversions.)
In the traditional IRA, one must take these RMD's at age 72 (Unless you reached the age of 70 ½ in 2019, the old rule applies and RMD's begin at age 70 1/2)
Bear in mind, inherited IRA's, whether Traditional or Roth have different distribution rules that must be met or one could face a 50% tax penalty on top of regular income taxes.
Okay, back to "Mary". She read all of the great advantages of doing a Roth Conversion but based on my first blog, wasn't sure if it was a good fit for her.
"Mary" is not a client so I wasn't aware of the details of her financial life but asking her a few questions, I learned the following:
- She was widowed and 68
- She had one child, an adult son who was single and a Social Worker
- She felt she would need to access her IRA for income before her required age 72
- Other than a small amount of money in her checking account, her IRA was her only asset
Based on this info, I was able to make some observations.
- Since she was widowed, the opportunity to leave her IRA to her spouse was not an option. If her spouse was alive and inherited her IRA, they would have been required to take RMD's at age 72 however, the IRA could have provided income throughout their life. Leaving the IRA (whether Traditional or Roth) to her son, doesn't allow for more than 10 years of tax deferral and the account must be emptied by the 10th year (under current tax law)
- By converting her IRA to a Roth and leaving it to her son, The Roth would be tax free income to him. However, if his income was not very high, inheriting a traditional IRA might not impact his taxes very much. By not converting, it would leave Mary with more money as she didn't need to use any money to pay the tax on the conversion.
- Mary didn't have any "extra" money to pay the tax on the conversion. She would have needed to take 100% of it from her IRA which could negate the advantage of converting.
- Mary told me she would need to access her IRA for income before her Required Minimum distribution date. Roth conversions work best if the money is left to potentially grow over time before withdrawing it. (There is also a five-year rule you need to be aware of when establishing a Roth IRA before withdrawals can be completely tax free). Since she was 68, she might not meet that 5 year rule in time.
After our discussion, it appeared a conversion wasn't in Mary's best interest. Wondering if a Roth Conversion makes sense for you?
Got questions? Or, if you would like to schedule a complimentary call, click HERE to see my calendar or just shoot me an email or give me a call.
In good health.
All the best.
Rick Fingerman, CFP®
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