Considering a Roth Conversion.
What is a Roth IRA?
A Roth IRA is an individual retirement account that is funded with after-tax dollars, so the contributions are not tax-deductible, but once you start withdrawing funds, the money is tax-free provided certain conditions are satisfied. Since investments in a Roth IRA have the potential to grow tax-free, that could lead to saving more over time. Plus, Roth IRAs don’t have required minimum distributions during the lifetime of the original owner, and Roth IRA assets may pass to heirs tax-free.
How is a Roth IRA Funded?
There are two ways to fund a Roth IRA – through a contribution or conversion. Roth IRA contributions are limited by income level. In general, you can contribute to a Roth IRA if you have taxable income and your modified adjusted gross income is either less than $194,000 if you are married filing jointly, or less than $132,000 if you are single, head of household, or married filing separately. If you own a tax deferred retirement account such as 401(k) or Traditional IRA, you are eligible to convert those dollars or securities to a Roth IRA and pay income taxes on that amount in the current year.
Why is now the right time to fund a Roth IRA?
With any investment, the ultimate consideration is after tax return. Current and future tax rates are the backdrop to whether utilizing a Roth IRA will pay off over time. Here are three reasons why a deeper evaluation of the benefits of a Roth IRA make even more sense right now:
First, in 2017 congress passed the Tax Cuts and Jobs Act, lowering the marginal tax rates for many. This has made the consideration of Roth IRA’s more appealing, by paying a lower tax rate now than previously while enjoying tax free growth for both an investor’s lifetime as well as future heirs. The Tax Cuts and Jobs act is set to sunset in 2025, unless renewed by congress. However, since tax laws are ultimately decided by congress a majority in one political party or another could revise of change the current laws. In stripping away the politics and looking only at the real picture, a new presidential administration or turnover in congress may bring about an appeal to this act and change in tax law, potentially leading to an increase in marginal tax rates from where they are currently.
Second, historically, if you were of the age that required a mandatory distribution from your retirement account, this had to be taken out before any conversions to a Roth IRA. This usually is not advantageous, as it results in more taxes in the current year and could potentially trigger a higher marginal tax bracket. However, through the CARES Act, congress has suspended Required Minimum Distributions for this year, and you can make a Roth IRA conversion with any dollar amount. Since Roth IRAs do not have required minimum distributions, it can be beneficial to convert assets from a traditional IRA to a Roth IRA to lower future RMDs and thus future tax liability. As the thinking goes, the more a Traditional IRA grows, the larger the future RMDs, and the larger the tax liability.
Third, the U.S. Federal Government is spending nearly three trillion dollars combating this horrible pandemic of Covid-19, increasing the current national deficit to 25 trillion dollars and most likely moving higher. The Congressional Budget Office is also predicting that the national debt will eclipse the annual economic output of the United States this year, 2020. That would be the deficit’s largest size as a portion of the economy since World War II. In addition, many states and local municipalities are feeling the pain of their own budget deficits. While we do not want to paint a bleak picture of the future, as we at Howe & Rusling believe in the American Spirit and know we will overcome this together, it is reasonable to ask, how are we going to pay for all this government spending? The likely answer is in part from some form of increase in taxes. No one knows the future, so this could be from an increase in sales tax, capital gains tax, property tax, income tax, etc. – maybe a combination of a few or all, but as previously stated, it does stand to reason that our collective taxes will be higher in the future.
What is the key takeaway?
Potential higher future tax rates is a risk that needs to be managed. One way to do so is to evaluate the impact of a Roth contribution or conversion. At Howe and Rusling, your Portfolio Manager, along with our financial planning team, can assess the detailed benefits of a Roth IRA for you and create a customized plan for your unique goals. Please reach out to us, as we are always concerned with helping you achieve future success.