For a certain group of investors, conversion of their Traditional IRA into a Roth IRA could be an effective move to hedge long-term bets against higher tax rates in the future. For some living in Michigan, this strategy could also be a very viable way to pass assets onto the next generation and help manage taxation to them at both federal and state levels.
Essentially, there are two groups that can potentially benefit when it comes to Roth Conversions: younger investors (which is relative), and the wealthy. The younger a person is when the conversion takes place, the better – because there is an eventual break-even point in number of years that the conversion will reach, depending on different variables like rate of return, taxes paid on conversion, and future tax bracket. This break-even could possibly happen anytime between nine and 17 years, depending on actual performance, tax rates applied when the conversion takes place, and future tax rates.1
The older, wealthy investor may benefit from Roth IRA conversion in two ways. First, Required Minimum Distributions are not required on Roth IRAs, so this asset can continue to grow, tax-free, as long as the investor lives and then can be transferred to the next generation and maintain tax-free status. An Inherited Roth IRA is subject to annual required withdrawals by the person who inherited it; but essentially, these can be tax-free withdrawals and will be stretched out over the new owner’s life expectancy.2 If you were to leave a Roth IRA to a 30-year-old, you would be able to make withdrawals over the next 54 years while the money in the Roth continues to accumulate, tax-free.
The second real benefit of the Roth Conversion for older, wealthy people looking to pass assets on to the next generation is that in Michigan, if you were born before 1946, you are not required to pay Michigan State income tax on your distribution up to $99,723 if filing jointly 3, which is currently 4.25%. Anyone born after that would be subject to the Michigan income tax on retirement distributions. So, if you were born before 1946 and are looking to pass IRA assets onto the next generation, you really should work with your tax advisor and develop a sound strategy to possibly convert these assets, so that you and your heirs will be able to completely avoid the state tax associated with regular distributions from inherited Traditional IRAs.
Traditional IRA conversions to a Roth IRA are not a one-shoe-fits-all type of scenario, by any means. Each individual situation will be dependent on the calculations and the numbers specific to that investor. The real-life application of Roth conversions should be done with both your tax consultant and your financial advisor to make sure that everyone is on the same page in terms of the reason driving the conversion and the timeline over which the conversion will happen. Conversions that I have executed for clients rarely happen all at one time, in an effort to manage the marginal income tax bracket’s effect on the last dollar earned.
Given the new tax laws that are in place for the next eight years, I would strongly advise that investors who have an interest in a Roth conversion strategy talk to their financial advisor and tax advisor to start the evaluation process.
This material is provided for general and educational purposes only and is not intended as tax, legal or investment advice (or for use to avoid penalties that may be imposed under U.S. Federal tax laws). Please consult your tax advisor for advice regarding your personal tax situation.
Conversion from a traditional IRA to a Roth first requires paying taxes on any pre-tax contributions, plus any gains. Additionally, the money used to pay these taxes cannot come from your traditional IRA without a 105 penalty, if you are under age 59.5.
Converted amounts can be distributed without penalty after five years, beginning January 1 of the year of conversion and ending on December 31 of the fifth year. Each conversion has a separate five-year holding period. If you are under 59.5 and take a distribution of converted amounts prior to the five-year holding period, you may be subject to the 10% premature penalty. Distribution of earnings before completing a five-year holding period and attaining age 59.5 may be subject to tax and 10% penalty.
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