In this week’s case study on “Money Talks,” we discussed a working couple, ages 61 and 63 who are considering a Roth IRA conversion. They have a healthy balance in their IRAs, and because of a change in the wife’s job, they will have significantly less income this year.
An IRA is generally pretax money that reduces taxable income for most people. For a married couple, filing jointly, who are both covered by a retirement plan at work, their modified adjusted gross income would need to be less than $98,000 to be eligible to take a full deduction up to the amount of their contribution. The deduction is phased out for MAGIs between $98,000 and $118,000, with no deduction once your income is above $118,000. Earnings on the contributions grow tax-deferred and are taxed at ordinary income rates when distributions are taken after age 59 ½.
Alternately, Roth IRA contributions are made with after tax money and the growth is considered tax-free after age 59 ½. However, unlike traditional IRAs, Roth IRAs are not subject to mandatory withdrawals at age 70 ½.
Their change in income for the year creates an opportunity for this couple to convert a portion of their IRA assets, while remaining in the same tax bracket. Converting the funds to a Roth IRA should reduce what they will need to withdraw as their mandatory withdrawals. The good news is the conversion doesn’t need to be all at once. They can spread the conversion over as many years as they want. With some tax planning, they should be able to convert an amount that would keep them within the upper limit of their current tax bracket without pushing them into a higher bracket.
If they don’t need the money in their IRA to cover spending needs at 70 ½ , it may be better to pay taxes on it now and then let it grow tax free in a Roth IRA, rather than be required to withdraw it in seven to nine years only to put it into another investment.
First, the couple will need to be able to pay the tax due on the converted assets from money outside of the IRA account. Not only is this a cash flow question, but it also involves a mathematical equation on determining the breakeven point. For example, if this couple were to convert $100,000, they will need to have between $30,000 and $41,000 outside of the account to pay the taxes. Assuming their Roth IRA can grow at a 6% rate of return, it will take seven to 10 years for them to break even. Additionally, in those 10 years, they will have to assume there will be no tax law changes that affects the tax-free benefits of Roth IRA distributions.
We highly recommend that anyone considering a Roth conversion consult a tax adviser or financial planner before making a conversion. There are rules to how you must convert IRA funds and how you must calculate the tax due. If your IRA is a pre-tax account, you simply pay the tax on the amount converted. If your IRA is a mix of pre-tax funds and nondeductible contributions, the calculations become complicated, because the amount converted is deemed to consist of a pro rata portion of the taxable and nontaxable dollars in the IRA.
If you have questions regarding how a Roth conversion may affect your taxes and cash flow, experts at Henssler Financial will be glad to help:
- Experts Request Form
- Email: experts@henssler.com
- Phone: 770-429-9166.
Disclosures
This article is meant to provide valuable background information on particular investments, NOT a recommendation to buy. The investments referenced within this article may currently be traded by Henssler Financial. All material presented is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. The contents are intended for general information purposes only. Information provided should not be the sole basis in making any decisions and is not intended to replace the advice of a qualified professional, such as a tax consultant, insurance adviser or attorney. Although this material is designed to provide accurate and authoritative information with respect to the subject matter, it may not apply in all situations. Readers are urged to consult with their adviser concerning specific situations and questions. This is not to be construed as an offer to buy or sell any financial instruments. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future profitability or expectations. As with all investments, there are associated inherent risks. Please obtain and review all financial material carefully before investing. Henssler is not licensed to offer or sell insurance products, and this overview is not to be construed as an offer to purchase any insurance products.
