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Considerations Before Converting to a Roth IRA
A client's age and investment time horizon, the value of assets being converted, and current and future tax brackets are among the factors a client needs to consider when deciding whether or not to convert assets to a Roth IRA.
Thanks to changes in Roth IRA conversion eligibility requirements, there is no longer a limit to a client's Modified Adjusted Gross Income for Roth IRA conversions. Taxpayers who are married and filing separate tax returns are also now eligible to convert assets to a Roth IRA.
(Please note that there are income limits for contributing to a Roth IRA. See product details for more information.)
Generally, the younger a person is, the longer he or she has to take advantage of the potential to benefit from tax-free growth. Also, younger people typically have less money in their IRAs, so taxes due upon a conversion could be less.
The longer money remains in a Roth IRA, the longer any potential earnings can accumulate tax free. The earnings may be withdrawn tax free provided certain conditions are met. What's more, if the account owner does not need the money in retirement, the tax-free benefits of his or her Roth IRA can "stretch" to beneficiaries.*
As long as a client has compensation, there is no maximum age for making annual contributions to a Roth IRA; however, there are still income eligibility requirements for contributing to a Roth IRA.
* For distributions to be tax free to beneficiaries the five-year aging requirement must be met; however, the time the original IRA owner held the Roth IRA counts toward the five years.
The amount of assets available to convert should be considered. A large amount converted in one year may push the client into a higher marginal tax bracket, resulting in a higher income tax rate for that year. Depending on their financial situation, it may make more economic sense for clients to convert only a portion of the assets or to convert the assets over a number of years, so the taxes due on the conversion are spread out over several years.
- Clients who expect to be in a higher tax bracket in retirement may potentially benefit from a Roth IRA conversion, as qualified distributions from Roth IRAs are federal income tax free provided certain requirements are met.1
- Clients will owe taxes when they make the conversion. Once they determine the amount of the tax, they should consider where the money will come from to make that payment. It is generally better not to pay those taxes with funds withdrawn from the IRA or other retirement accounts since doing so could generate yet more tax liability and reduce the additional advantage of potential tax-free growth on the full amount of the conversion.
- If the client has made nondeductible IRA contributions, the client must complete IRS Form 8606, which calculates the tax-free return of basis needed to determine the taxable amount of the IRA distribution.2 This is filed with the client's tax return for the year in which the conversion is made.
- Eligible Roth 401(k) and 403(b) assets may be rolled over to a Roth IRA to avoid MRDs (minimum required distributions) from those accounts during a client's lifetime. With other tax-advantaged retirement savings accounts, MRDs are generally required to be taken each year,3 triggering additional tax liability.
- A distribution from a Roth IRA is tax free and penalty free, provided the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, disability, qualified first-time home purchase, or death.
- Form 8606 cannot be filed for a married couple together. If both converted IRAs in a tax year, each must complete a separate Form 8606. Other appropriate forms required by the IRA custodian must also be completed.
- Generally, MRDs are required for participants age 72 and older. The change in the MRD age requirement from 70½ to 72 only applies to individuals who turn 70½ on or after 1/1/20. Please speak with your tax advisor regarding the impact of the SECURE Act on future MRDs. Please note, Roth IRAs are exempt from MRDs.
- Clients with large estates who do not need their traditional IRA assets for income during retirement may want to consider a Roth IRA conversion. By paying the income taxes on the conversion, their beneficiaries will not be subject to income taxes on later distributions from the Roth IRA, provided the distribution has met the five-year aging period requirement.
- If the client's taxable estate is large enough to be subject to federal estate taxes, the conversion could reduce the size of the current estate by the amount of the taxes paid on it, thus potentially offsetting future estate taxes.
- Fidelity does not provide legal or tax advice. The information herein is general and educational in nature and should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact investment results. Fidelity cannot guarantee that the information herein is accurate, complete, or timely. Fidelity makes no warranties with regard to such information or results obtained by its use and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Consult an attorney or tax professional regarding your specific situation.