We have observed that our clients are knowledgeable about Roth IRAs but may not fully understand all the benefits of a Roth rollover strategy. If they are aware about the availability of a Roth rollover, interest may wane when they learn that transferring funds from the IRA to the Roth is taxable. Paying tax ahead of time is not a typical tax planning strategy, but we have found that in the current tax environment and with potential for higher rates longer-term, there are situations where paying tax early may be advantageous.
The Roth IRA was established by the Taxpayer Relief Act of 1997 (Public Law 105-34) and named for its chief legislative sponsor, Senator William Roth of Delaware. The idea behind its structure was to encourage Americans to save more for retirement. While there is no tax deduction for contributions to a Roth IRA, the earnings and appreciation from a Roth IRA account are never subject to Federal or state tax even when the funds are withdrawn. An account must exist for five years, and the account owner must be over 59.5 years old at the time of distribution to receive this tax-free treatment. There are potential penalties and taxes if these requirements are not met when funds are distributed from the Roth account.
Currently, the annual Roth IRA contribution limit is $6,000 (for both 2020 and 2019). If you are over age 50, you can add an additional $1,000 to the annual limit. There are also income limitations, particularly for high-income earners, that may reduce how much can be contributed each year. These limitations for annual contributions do not apply when a person receives a lump-sum distribution from a qualified retirement plan or simply wants to roll over an existing IRA balance to a Roth IRA.
When a lump sum or IRA is rolled to a Roth, the distribution is generally taxable unless there is a non-taxable portion. As mentioned above, the benefits of the Roth IRA are that the future appreciation and income in the account is not subject to any tax. Also, required minimum distributions (or RMDs) are not required for Roth IRA accounts. For a traditional IRA, at age 72, the owner must begin to take annual RMDs and pay the related taxes on such distributions. Another advantage, and often a very important consideration, is that a person who inherits a Roth IRA enjoys the Roth IRA benefits for up to ten years before a full distribution is required and that full distribution is still not subject to any tax to the beneficiary.
When considering a Roth IRA rollover, the value of future non-taxability ought to be weighed against the immediate tax being paid. Traditionally, most advisors and IRA owners attempt to defer the payment of taxes and delay distributions. With U.S. income tax rates at historically low levels, accelerating the taxation of IRA and 401k balances in exchange for tax-free growth in a Roth IRA is worth exploring.
In a Roth conversion, the IRA or 401k owner will distribute part or all the IRA or 401k balance and roll it to a Roth IRA. Taxes are due on the distribution unless there is non-taxable portion. For some, the most tax-efficient approach is to execute the Roth rollover during the period between retirement and the start of traditional IRA RMDs, as the taxable income during that period is often at its lowest level, so income resulting from the conversion enjoys lower tax rates.
In one client situation, we used the Roth strategy to convert about $1.2 million of IRA assets into a Roth IRA over a 10-year period and ensured that the client stayed below the 24% tax bracket. The impact was that at that 10-year mark, his RMD was projected to be reduced from $111,000 per year to $40,000 per year. The Roth assets would have grown to about $2.0 million at year ten, using a 6% assumed rate of return. The client not only reduced his current tax level in the future by reducing the RMD required but also created tax-free growth that would be passed on to the next generation, ultimately saving hundreds of thousands of dollars of tax over his life and the ten years after death (at which time the Roth would have to be liquidated).
Like all planning, there is not a “one size fits all” approach to this Roth conversion strategy. At the same time, as shown above, it may be worth the effort to explore whether it may be advantageous for you.