Roth IRA Conversions After Tax Reform…Still a good idea?


Now may be a good time to consider a Roth IRA Conversion.

When it comes to retirement planning, many people focus on picking the right mix of investments. And while asset allocation is undoubtedly important, it’s not the only factor to consider. Another crucial element is tax diversification.

 With the market being down lately, many Americans are feeling shocked about their low balances in investments. However, this also presents an opportunity for them as Roth conversions can help make up some of those lost funds!

One way to achieve tax diversification is through a Roth IRA conversion. This is when you convert a traditional IRA into a Roth IRA. With a traditional IRA, you contribute pre-tax dollars, and the money grows tax-deferred. With a Roth IRA, you contribute after-tax dollars, and the money grows tax-free. That means you won’t have to pay any taxes when you withdraw the money in retirement.

There are a few things to keep in mind with a Roth conversion. First, you will have to pay taxes on the amount you convert. Second, you must ensure that your Roth IRA has enough assets to cover your expenses in retirement. And third, you need to consider how a Roth conversion will impact your overall retirement plan.

But if done correctly, a Roth conversion can be an excellent way to diversify your retirement plan and reduce your tax liability in retirement. So if you’re looking for ways to diversify your retirement income, a Roth IRA conversion could be worth considering.

Twenty years ago, the Roth IRA became available to investors as a financial tool for their estate planning needs. These accounts have maintained their popularity because, unlike their traditional IRA counterpart, a Roth IRA provides account owners tax-free income during retirement.

Many people choose to convert their traditional IRA or 401(k) plan into a Roth IRA to benefit from this long-term tax advantage. However, the recently enacted Tax Cuts Job Act has removed one helpful opportunity: today In other words, there’s no going back once the conversion is done.

You can think of these recharacterizations as a second look at whether the conversion made financial sense. For example, Robert decides to convert a $100,000 traditional IRA to a Roth IRA. When Robert does this, he has to pay income tax on the $100,000. This isn’t as bad of a deal as it sounds because now the money is in a Roth IRA, where all the withdrawals will eventually be tax-free. When Robert retires, he’ll have “tax-free” income from the Roth IRA instead of paying income tax on each withdrawal if it were still in the traditional IRA. In the past, if the market were to decline to, say, $90,000, Robert could recharacterize — or undo — the conversion. This is important because he had to pay income tax on the full $100,000 of the conversion, but his assets have declined in value to only $90,000. So, Robert would be paying income tax on a “phantom” $10,000 IRA conversion. Now, this second look that a recharacterization offered is closed, so a Roth IRA conversion is just a little riskier than it used to be.

Implications For Loved Ones

Many people who create IRAs and those who inherit them are unfamiliar with the rules that apply to them. There are several basic scenarios that will result in different consequences for your loved ones in the event you pass away and leave behind an IRA.

First, if you die before spending all the money in your IRA, you can leave the retirement account to your surviving children, grandchildren, or other beneficiaries you have designated in your estate plan.

Second, the type of IRA — in other words, whether it is a traditional IRA versus a Roth IRA — is essential as it vastly affects the amount of benefit your loved ones will receive. For example, when you leave behind a traditional IRA, your family will pay income taxes on the money they withdraw when it is taken out of the account. On the other hand, if you leave behind a Roth IRA, the money will be income tax-free for your family. Although both types of accounts are subject to the estate tax (or death tax), the death tax is likely a non-issue for most people now, as the federal estate exemption is presently over $12 million per person (but will be reduced after 2025).

Third, you can create an IRA trust as part of your comprehensive estate plan. An IRA trust is a special trust that is purposefully designed to receive IRA distributions for the benefit of your loved ones after you die. This powerful tool maximizes the benefit to your family upon your passing and can be used for both traditional or Roth IRAs. So, whether you decide to convert or not, you still need to consider an IRA trust.

Finally, although tax reform altered the flexibility of IRA conversions by removing the ability to undo them with a recharacterization, a conversion may still be an excellent financial planning option for some. As you work with your financial and tax advisors on your conversions, consider your beneficiary designations and whether an IRA trust might be right for you.

Contact an Estate Planning Professional

There are several factors that should be considered when choosing financial and estate planning tools. Always work with a knowledgeable financial and tax professional. Then, work with us as your estate planning professional, so we can achieve your goals and maximize the benefit to your loved ones.

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