With the stretch IRA gone thanks to the SECURE Act, it might be time to revisit your estate plan. If you have money in a traditional IRA, you might consider a Roth IRA conversion.
With a Roth conversion, taxes are paid up front, but then the conversion plus any earnings become tax free upon distribution
Roth conversions are subject to a five-year rule, meaning you need to wait five tax years before taking a distribution of the converted amount, or else be subject to a tax penalty
Now that the SECURE Act has passed, financial professionals are taking a step back and figuring out how it affects those saving for retirement.
One of the biggest issues, according to Dara Luber, senior manager, retirement product at TD Ameritrade, is the loss of the “stretch” IRA.
“A big piece of the SECURE Act is changing how nonspouse beneficiaries inherit IRAs,” said Luber. “Before, you could take distributions over a lifetime, but now you have to do it in 10 years, creating a potentially bigger tax bill for heirs.”
A Roth IRA conversion might help families avoid that stress on posterity. Here’s what you need to know.
A Roth conversion allows you to take a traditional IRA and turn it into a Roth IRA. For those who plan to pass their IRA on to nonspouse heirs after they pass, a Roth conversion can make sense, thanks to recent changes as a result of the SECURE Act.
In the past, an inherited IRA could be “stretched out” over the beneficiary’s lifetime, allowing them to draw down the balance while minimizing the tax hit. But now that the stretch IRA has been eliminated, a nonspouse beneficiary has only 10 years to draw down the balance. That means bigger required minimum distributions—and potentially bigger tax consequences.
For those who wish to pass on their wealth without passing on the taxes, a Roth IRA conversion can be the answer. With a Roth conversion, the traditional IRA is shifted into a Roth account, which comes with no required minimum distributions (RMDs) during the account owner’s lifetime and no federal taxes on withdrawals in retirement.
“The original owner takes the tax hit, but when they pass, the taxes are already paid,” said Luber. “It could be attractive for those who want to get rid of the tax bite on behalf of their children.” The kids must take RMDs but get to skip the taxes.
It’s important to keep in mind that a Roth IRA conversion has some basic requirements:
It’s important to note that a Roth IRA is funded with after-tax dollars, while a traditional IRA is funded with pre-tax dollars. As a result, when you complete your IRA conversion, you need to make sure everything going into the Roth has been taxed. This could mean a big tax bill in the year you convert, because you’ll have to pay taxes on your original contributions as well as any gains you’ve seen in the meantime.
Another consideration: if you use proceeds from your Roth IRA conversion to help pay the taxes, you might be subject to a 10% early withdrawal penalty if you’re younger than 59 1/2. Check with a tax professional or rollover consultants before making your move.
As you move forward with your Roth conversion, there are three main choices:
The good news is that you don’t have to complete a Roth conversion all at once. It’s possible to convert only a portion of your account at a time, reducing your tax bill in a given year.
Before you convert your traditional IRA to a Roth account, consider how much you can afford to pay in taxes. With advance planning, it’s possible to move your money into a Roth and pay the taxes in affordable chunks.
A Roth IRA conversion can be a smart move if you want to lower your taxable income for later or if you want to avoid required minimum distributions once you are older. Additionally, a Roth conversion can make sense if you know that your heirs will receive your IRA when you pass, and you don’t want them to deal with the tax bill.
However, it’s important to understand the consequences when you convert an IRA to a Roth IRA. If you’ll need the money in the next five years, or if the conversion will boost your taxable income in a way you can’t afford, it might be best to hold off or modify your plan.
“This isn’t a strategy to use lightly,” said Luber. “Make sure you plan ahead. It can be a good way to pass down money to kids, but you need to understand the consequences to your own bottom line.”
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