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The Roth IRA has become a popular planning tool since it was established by the Taxpayer Relief Act of 1997. Originally envisioned as a way for Americans of more modest means to efficiently transfer wealth to the next generation, the Roth IRA offers a number of potential advantages over a Traditional IRA that are particularly attractive to those that are more affluent. While there are many variables to consider when determining which type of IRA is best suited to an individual’s needs, the removal of income limits on Roth IRA conversions has made this tool available to wealthier individuals that would otherwise not qualify to make a Roth IRA contribution because of income-based restrictions
How does it work?
Assets that are invested in a tax-deferred Traditional IRA or employer-sponsored retirement plan- such as a 401 (k), 403 (b), or 457 (b) – may be repositioned to a tax-free Roth IRA. Because these pre-tax savings plans were not previously subject to tax, the amount converted is included as income and taxed at your marginal or alternative minimum tax rate. The converted assets will grow tax-free, and qualified distributions are never taxed.
What’s the catch?
While conceptually straightforward, there are rules that must be adhered to. Ineligible Roth IRA contributions (including amounts converted) are subject to an excess contribution penalty equal to 6% of the remaining excess contribution at year end. Left uncorrected the penalty continues to grow until a corrective distribution (equal to the ineligible contribution and any earnings) is made. Left unchecked, an error of this sort could be very costly.
In addition, the IRA aggregation rule stipulates that multiple IRA accounts must be combined and treated as one account for purposes of calculating the tax consequences of a distribution, and the pro-rata rule governs the percentage of the account that is subject to tax. In effect, this eliminates the ability to separate pre-tax and post-tax contributions and convert only the post-tax contributions from a Traditional IRA to a Roth.
Who benefits the most from a Roth IRA conversion?
In general, the people that would benefit most from a Roth IRA contribution will also benefit most from a Roth IRA conversion. These include:
- People that expect to be in the same or a higher tax bracket in retirement.
- Those with sufficient cash available to pay the taxes due on the Roth IRA conversion without using retirement funds.
- Those that may not need the funds for retirement and wish to leave them to heirs.
- Those with a high investment risk tolerance and long time horizon will maximize the benefits of the Roth’s tax-free growth.
There is a lot to like about the Roth IRA, and the removal of income limitations on Roth IRA conversions has made this tool available to those wealthier individuals that tend to derive the most benefit from it. Income and assets alone, however, are only part of the story. The Roth IRA can play a valuable role in most anyone’s retirement income strategy. Check with your Financial Advisor or Accountant for how a conversion would apply to your situation; it can be complicated! The more you know, the better your decision on how to finance the fulfilling 30+ years retirement lifestyle you want!
John Male, CFP®, RICP®
The Gassman Financial Group
The Retirement Maven™
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