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Roth IRA Advantages, the SECURE ACT &
Roth Conversion
From the Director of Retirement Research
Depending on your circumstances, Roth conversions can save you money on taxes:
Tax-free withdrawals
Unlike withdrawals from traditional IRAs and tax-favored retirement plans like SEPs and 401(k)s, qualified Roth IRA withdrawals are federal and state-income-tax-free. What counts as a qualified withdrawal? One that is taken after you, as the Roth account owner, have met both of the following requirements:
1. You’ve had at least one Roth IRA open for more than five years.
2. You’ve reached age 59½ or become disabled or dead.
For purposes of meeting the five-year requirement, the clock starts ticking on the first day of the tax year for which you make your initial contribution to your first Roth account. That initial contribution can be a regular annual contribution, or it can be a conversion contribution. For example, say your initial Roth pay-in was an annual contribution made on 4/1/18 for your 2017 tax year. The five-year clock started ticking on 1/1/17 (the beginning of the tax year for which the contribution was made), and you will meet the five-year requirement on 1/1/22.
Exemption from required minimum distribution rules
Unlike with a traditional IRA and other types of tax-favored retirement accounts, you don’t have to start taking annual required minimum distributions (RMDs) from a Roth account after reaching age 72. Instead, you can leave the account untouched and earning tax-free income for as long as you live. This important privilege makes your Roth IRA a great asset to leave to your heirs as long as you don’t need the Roth money for your own retirement.
Roth conversion can provide insurance against future tax rate increases
Today’s federal income tax rates might be the lowest you’ll see for the rest of your life. Thanks to the Tax Cuts and Jobs Act, the rates shown below apply for 2020. The insurance against future tax-rate increases comes from the fact that Roth account earnings can be withdrawn as tax-free qualified withdrawals. In contrast, earnings that accumulate in other types of tax-favored retirement accounts will be subject to whatever the tax rates happen to be when the earnings are withdrawn. Those rates could be a lot higher than now.
SECURE ACT Strategy – Roth conversion
With the SECURE Act comes the demise of the stretch strategy – and that could cost your loved ones if you don’t revisit your retirement income plan.
It’s long been common practice to stretch IRA and 401(k) distributions over the life of the beneficiary. A smart strategy for two reasons:
• It allows the tax-advantaged nature of retirement accounts to continue for years, even decades. Investments continue to grow tax-deferred inside the IRA or 401(k).
• Spreading out the taxable distributions can help reduce the tax burden.
But with the SECURE Act now in effect, beneficiaries will have to fully distribute taxable accounts within 10 years of the account holder’s death. That could push your loved ones into a higher tax bracket.
The stretch strategy’s undoing is no surprise: It’s been proposed for years in government, because it would generate generous tax revenue. The SECURE Act is expected to raise roughly $16.4 billion in revenue over the next 10 years. Almost all of it – $15.7 billion of the $16.4 billion – will come from the elimination of the stretch option.
Is there a viable alternative to the stretch strategy?
We can’t fully replicate the tax-deferred nature of the IRA or 401(k) on inherited accounts. But charitable remainder trusts and insurance products could provide similar benefits. People should focus on more tax-efficient strategies as part of their retirement and estate planning. Bracket-bumping Roth conversions is the strategy primed to give beneficiaries a boost in the SECURE Act era.
Reach out for help with the Roth conversion strategy.
Roth IRAs will still be subject to the 10-year distribution period under the SECURE Act, but distributions from the Roth won’t impact the beneficiary’s taxable income. Roth conversions require the account owners to plan in advance. If done correctly, they can cancel out the taxes that come with a shortened distribution period.
Let’s look at a quick example. You leave $1,000,000 in an IRA to your child – a 40-year-old, single professional who earns $120,000 a year. Under previous rules, they could stretch out distributions over 44 years. The first-year distribution would be about $22,727.27. This wouldn’t push them into a higher tax bracket.
Tax Brackets For 2020
Taxable income (i.e. income minus deductions and exemptions) between:
Married joint return Single Head of household
$0–$19,750 10% $0–$9,875 10% $0–$14,100 10%
$19,751–$80,250 12% $9,876–$40,125 12% $14,101–$53,700 12%
$80,251–$171,050 22% $40,126–$85,525 22% $53,701–$85,500 22%
$171,051–$326,600 24% $85,526–$163,300 24% $85,501–$163,300 24%
$326,601–$414,700 32% $163,301–$207,350 32% $163,301–$207,350 32%
$414,701–$622,050 35% $207,351–$518,400 35% $207,351–$518,400 35%
Over $622,050 37% over $518,400 37% over $518,401 37%
Under the SECURE Act, your child will have to distribute the account over 10 years. They decide to spread it out evenly, taking out $100,000 in the first year. This pushes them up to $220,000 of income with $44,000 of the distribution into the 32% tax bracket and roughly $12,600 of the distribution into the 35% tax bracket. This significantly increases the taxes they’d pay on the IRA.
Instead of leaving the money in an IRA, you can start doing strategic Roth conversions to alleviate that tax burden before you die. Let’s say one parent was in the 24% tax bracket with $100,000 of income. They could start doing Roth conversions early in retirement to take advantage of their full tax bracket, up to roughly $160,000, without going to the next tax rate. The Roth conversation strategy is especially more valuable now, when distributions are stacked into 10 years under the SECURE Act. You should start working with a knowledgeable advisor now as the SECURE Act is law.
The bottom line
Low current tax cost for converting + insurance against higher tax rates in future years by converting your taxable retirement accounts to a Roth account + tax-free retirement income + helping your beneficiaries eliminate a tax burden = great idea.
Contact us to start the conversation.
Distributions from traditional IRAs and employer sponsored retirement plans are taxed as ordinary income and, if taken prior to reaching age 59½, may be subject to an additional 10% IRS tax penalty. A Roth IRA offers tax free withdrawals on taxable contributions. To qualify for the tax-free and penalty-free withdrawal of earnings, a Roth IRA must be in place for at least five tax years, and the distribution must take place after age 59½ or due to death, disability, or a first time home purchase (up to a $10,000 lifetime maximum). Converting from a traditional IRA to a Roth IRA is a taxable event.
