Taking withdrawals tax-free during retirement is just one benefit of converting assets to a Roth, asserts CNBC in the article “Here’s how Roth IRA conversions can deliver some lucrative hidden benefits.” To understand the others, let’s first clarify the retirement benefits of a Roth IRA. Unlike traditional IRAs, where withdrawals are taxed as income, Roth IRA withdrawals are generally tax free, once the owner reaches 59½. There are also no required minimum distributions—the annual amount that other retirement accounts require be withdrawn starting at age 70½—as long as the owner is alive.
The downside? Contributions are not tax-deductible the same way they are with traditional IRAs or 401(k) plans. If you move pre-tax money from one of those accounts to a Roth IRA, you have to pay taxes on the amount that is moved.
However, federal taxes are now relatively low. If you were to do a conversion in the future, when federal taxes might be higher, it could cost more. It’s not likely that taxes are going down.
There are contributions and income limits that apply to direct contributions made to Roth IRAs. However, those restrictions are not in place for assets transferred from other qualified accounts. There may, however, be valid reasons not to move an entire retirement account to a Roth, or to limit how much is converted in any given year. Some of these rules can get confusing, so working with a professional is recommended.
Some situations where a Roth conversion makes sense:
When one spouse dies, the household income may not drop all that much. Being taxed as a single filer generates more in taxes than a joint return. A household income of $60,000 puts a married couple in the 12% bracket, while a single filer with that income is in the 22% bracket. The standard deduction for singles is also half that of marrieds: $12,000 vs. $24,400 in 2019. If the couple did a Roth conversion while both are living, the surviving spouse would have less of a tax burden.
If someone is planning on an early retirement, regular IRAs and 401(k)s have a 10% penalty for withdrawals before 59½. Roth contributions can be withdrawn anytime penalty-free, although the earnings must be left in the account to avoid penalties and taxes. For money that was converted to a Roth IRA, just don’t touch it for five years. In addition, only the contributions can be taken out, not the earnings.
Relocating won’t make any changes in federal tax burdens, but it may make a difference for state taxes. If a couple plans on moving to a state with higher taxes in the future, the time to convert money to a Roth IRA would be before moving. If the future new home is in a low or no state tax state, then waiting until after the move would be better.
For a small business owner who can use the 20% deduction on pass-through income, that is, income that flows from the business to the personal tax return—then a Roth rollover may help reduce the amount paid in taxes. If the taxpayer is eligible, it applies to the lesser of either the taxable income (minus capital gains) or the qualified business income. Therefore, the more money to which that deduction may apply, the less will be owed in taxes.
References: CNBC (December 12, 2019) “Here’s how Roth IRA conversions can deliver some lucrative hidden benefits”