Are you considering converting your IRA to a Roth IRA? Having your retirement savings in a Roth account can be extremely beneficial if you wish to avoid Required Minimum Distributions (RMDs), want your money to grow tax-free, or if you plan to leave the account to your heirs. While traditional IRAs are subject to a ten-year withdrawal schedule at ordinary income tax rates when the IRA owner dies, Roth accounts pass to heirs tax-free. Additionally, the new SECURE act allows for Roth accounts to continue growing tax-free for up to 10 years after the death of the account holder.
The benefits of Roth accounts are clear; however, if you are thinking about converting funds from your traditional IRA into a Roth IRA, here are a few things you should consider with your retirement planning services financial advisor.
What is a Roth Conversion?
Essentially, a Roth conversion includes converting all or part of a traditional IRA to a Roth IRA by paying taxes on that money. Once your money is in a Roth account, you will be exempt from RMDs. Your money will grow tax-free and transition to your heirs tax-free. If they choose, your heirs can allow the money to continue to grow tax-free for up to 10 years after your death.
Roth conversion strategies can take the form of a Backdoor Roth, Mega-Backdoor Roth, or Roth conversion. Work with your financial advisor to determine the best strategy for converting your money to a Roth account.
The main downside of a Roth conversion is the taxes that you have to pay when you convert the money. Two related strategies can increase the efficacy of Roth conversions.
Try Offsetting your Roth Conversion with a Charitable Donation
One strategy to consider is to offset your Roth conversion with a charitable donation. You will be able to take a tax deduction for your donation, offsetting the taxes you pay on your Roth conversion.
It looks something like this. Let’s say that you have a sizable IRA or 401(k) and you desire to convert it to Roth. You participate in a $75,000 Roth conversion. Because that will be counted as $75,000 of income, you will have to pay taxes on that conversion. You can offset that by also making a $75,000 contribution to a charity or group of charities. If you don’t want to give that much all at once or you are not sure who to give to yet, you can use a Donor Advisor Fund (DAF), which will allow you to get the deduction upfront but parcel out the funds over time.
So, although your income for the year increased by $75,000, you offset that increase by making a charitable contribution of the same amount. Make sure to discuss this with your tax advisor first.
Pay the Conversion Taxes with Outside Funds
When paying the tax on a Roth conversion, many investors choose to withhold the tax amount from the amount being converted. These individuals are passing up an opportunity. Where possible, the tax on Roth conversions is best paid by outside funds.
Consider this example: You are converting $100,000 from your IRA to your Roth IRA and the tax due is $15,000. If you take the normal route and withhold the $15,000, you obviously end up with only $85,000 in your Roth. But what this means is that by paying tax with other money, you are effectively contributing an additional $15,000 to your Roth, more than two years’ worth of annual contributions. That extra contribution will then benefit from tax-free growth and withdrawal. The nitty-gritty math will show a real increase in long-term value resulting from this strategy.
As you consider executing a Roth conversion, ensure that you are working with a financial advisor you trust. At TrueNorth Wealth, our fee-based financial advisors will ensure that you are getting the most out of your retirement savings and that you are adequately prepared to reach your retirement goals.