• The Top 5 Funding Reminders for Roth IRAs

    By: Denise Appleby, MJ, CISP, CRC, CRPS, CRSP, APA

    The rules of Roth IRAs create multiple tax-saving opportunities for Roth funding.

    Many consider Roth IRAs a gold standard for retirement savings because they provide a source of tax-free income during retirement. This tax-free benefit includes tax-deferred earnings, which are tax-free for those eligible for qualified distributions. Taxpayers who choose to fund Roth IRAs instead of traditional IRAs pay taxes upfront in exchange for this benefit. However, the promise of tax-free income is only one of the factors that must be considered, and taxpayers who choose Roth must also consider various strategies and operational requirements. The following reminders are a good start.

    1. After-tax 401(k) contributions: an opportunity for tax-free conversions

    Once a plan participant is eligible to make withdrawals from their 401(k) or other type of employer plan account (401(k)), eligible amounts may be rolled over to an IRA or another eligible retirement plan. For those who want to continue tax deferral until they are ready to take distributions, a traditional IRA is a common choice for rolling over assets from 401(k)s. However, if the 401(k) account includes after-tax amounts, that after-tax balance is an opportunity for a tax-free conversion.

    Unlike a conversion of pre-tax amounts, for which a suitability assessment is often recommended because it is taxable when converted, the conversion of an after-tax amount is tax-free. Therefore, no suitability assessment is needed. Further, any earnings on the after-tax amount would eventually become tax-free in a Roth IRA when you are eligible for a qualified distribution—a contrast with earnings that accrue in a traditional IRA, which would be taxable when distributed.

    Essential Tip: If you want to roll over their 401(k) account to an IRA, and that 401(k) includes an after-tax amount, instruct the plan administrator to split the distribution and send the after-tax amount to your Roth IRA. Doing so helps to ensure that the after-tax amount is not sent to your traditional IRA.

    2. Micro conversions for tax management

    Roth conversions are included in income, with any pre-tax amount being taxable for the year the conversion occurs. However, converting small amounts over time can mitigate the tax impact. For example, an individual who wants to convert $500,000 could make $50,000 yearly conversions over ten years instead of converting the entire $500,000 all at once. This strategy is commonly referred to as micro-conversions.

    This strategy can also be used to stay within a tax bracket in cases where a conversion could cause some of the individual’s income to be taxed at a higher tax bracket.

    Ideally, you would consult with your tax advisor to project the tax impact of the conversion and help them determine how much would be an ideal amount to convert each year.

    3. Tax withholding is not conversion

    If you want to have taxes withheld from the requested conversion amount, the withholding tax is not included in the conversion. As a result, the amount withheld for taxes will be subject to the (10% additional tax) 10% early distribution penalty unless an exception applies.

    Example 1: 45-year-old Sean’s Traditional Number 12345 had a balance of $100,000—all of which is pre-tax amounts. He instructed his IRA custodian to convert Traditional IRA Number 12345 to his Roth IRA Number 67890 and withhold 20% for federal taxes. Based on his instructions:

    • $20,000 was sent to the IRS for federal tax withholding.
    • $80,000 was deposited to Roth IRA #64890 as a Roth conversion.

    The result:

    • $100,000 is included in Sean’s income for the year.
    • $100,000 is taxable.
    • $80,000 is not subject to the 10% early distribution penalty.
    • $20,000 is subject to the 10% early distribution penalty because it is not part of the Roth conversion.

    If Sean had funds in a regular savings account (not a tax-deferred account), he could pay the income tax from that account instead of his traditional IRA.

    Consideration: An analysis should be done to determine if it makes good tax sense for Sean to perform a Roth conversion if it requires paying the income tax from his IRA.

    4. Roth conversion amounts must be rollover eligible

    A Roth IRA conversion is a two-part transaction:

    1. A distribution from the traditional IRA, and
    2. A rollover to the Roth IRA- which is treated as a conversion.

    Consequently, like a rollover, only eligible amounts can be included in the amount credited to the Roth IRA.

    An example of an amount that is not eligible to be rolled over is a required minimum distribution (RMD). If you are at least 73 this year, you must take RMDs due from your traditional IRA before any Roth conversion.

    Reminder: If the funds are in an employer plan and you are still employed by the plan sponsor, you should check with the plan administrator to determine if you must take an RMD for the year.

    5. Let conversion amounts sit and stay for at least 5-years

    A Roth IRA conversion is not subject to the 10% early distribution penalty, regardless of the age at which it occurs. However, distribution from a Roth conversion amount is subject to the 10% early distribution penalty if it occurs before it has aged in the Roth IRA for at least five years.

    Example 2: Using the facts from Sean’s example above, assume that the conversion was done in 2024. If Sean withdraws any amount from that $80,000 conversion before January 1, 2029, it would be subject to the 10% early distribution penalty unless he qualifies for an exception.

    Reminder: The 10% early distribution penalty does not apply if you are at least age 59 ½ when the distribution is made or if the distribution qualifies for an exception to the penalty.

    Note: Under the ordering rules, any regular Roth IRA contribution or conversions done in previous years would be drawn before Sean’s 2024 Roth conversion.

    Disclaimer

    The tips provided in this article are generally operational in nature. The decision of which to choose—Roth IRAs vs. traditional—is more complex and requires a suitability analysis. However, using some of the strategies mentioned in this article can lessen any immediate tax effect. Except for the tax-free conversion of after-tax funds from a 401(k), the assistance of a tax professional should be engaged to help determine suitability.

    Original Post by Horsesmouth, LLC.: https://www.savvyira.com/article.aspx?a=99588