This advertisement provided courtesy of Prudential.
Everyone looks for ways to save money, and to make their money work harder – and longer. With pensions disappearing and reductions in employer match programs, it is important to consider financial planning tools that address long-term retirement and tax situations. One such tool is the Roth IRA.
A traditional IRA permits potentially before-tax contributions which enjoy tax-deferred earnings. A Roth IRA, however, only allows after-tax contributions, but can potentially provide income-tax-free earnings for retirement and is not subject to the required distribution rules that apply to a traditional IRA during the life of the Roth IRA owner.
For many, it is an opportunity to invest money in one of these tax-advantaged retirement savings. But keep in mind that you need to hold the Roth for five tax years and either be over age 59 ½, disabled or die to qualify for income tax free treatment. If you need to access the funds before you are age 59 1/2, a tax penalty may also apply on taxable amounts withdrawn. A separate five-year clock also runs for tax penalties on converted amounts. While you would not be subject to tax again on the converted amounts, if you withdraw these funds within five years of conversion, there is a 10% tax penalty on the amounts that would have been taxable at the time of conversion.
For those considering a Roth conversion, here are answers to some commonly asked questions.
1. Do I need to hold my Roth IRA for a long period of time for it to make sense to convert?
In most cases, no. If you think your income tax rates will be the same or higher in retirement, you do not have to hold the Roth for any period of time for the conversion to make sense. Given the potential for tax rate increases, this may be the situation for many retirees. If you think your income tax rates will be lower in retirement, then you may need to hold the Roth for a period of time before you make money or it pays economically to have it converted.
2. Do I have to do a complicated financial analysis to determine if a Roth conversion makes sense for me?
Only if you think rates will be lower when you take distributions from the Roth IRA. If you do think you will be paying tax at lower rates in the future, then a financial professional can help you determine how long you will need to hold the Roth IRA for it to make sense for you to convert. The point in time when it becomes profitable for you to have it converted is sometimes referred to as the “crossover point.” In general, though, if retirement is many years away, a Roth conversion may well make sense even if you are going to pay tax at conversion at a rate higher than what you will pay in retirement at distribution.
3. My tax rates will be lower in retirement so I should not convert to a Roth IRA.
This is a common belief, but many modern retirees are working and have some wage income and, with Social Security and distributions from other retirement assets, are actually in the same or a higher tax bracket. Also, given current budget deficits and the cost of funding future Social Security and Medicare payments and the new health care legislation, tax rates may be headed up.
4. I will not be eligible for loans or financial aid for my child’s college education.
It is true that converting to a Roth may raise your income level in the year of conversion and reduce eligibility for college loans. However, unless you convert over a period of years, this would be a one-year impact and needs to be considered as a factor in the conversion analysis. It should not be seen as a deal breaker.
5. Will it increase the tax on my Social Security benefit and increase my Medicare Part B premium?
Like the financial aid concern, the increased income from the Roth conversion could make more of your Social Security benefit subject to income tax and it could increase your Medicare Part B premium (now means tested). But these should be one year impacts and should simply be factored into the Roth conversion analysis. These should not be deal breakers. Indeed, you may pay less tax on your Social Security benefit or less Medicare Part B premium in the future since Roth distributions are not included in the applicable calculations.
6. Paying taxes to the government early is bad tax planning.
Usually it is bad tax planning to pay your taxes early and, in effect, make an interest free loan to the government. But the rules may be different now that tax rates could be headed up. By choosing not to pay the tax now, you may also be choosing to pay the tax later at a higher rate (remember, someone will eventually pay income tax on the IRA earnings, either you or your spouse or your children). Now might be a great time to pay taxes at the lower rates and avoid the rate increases on the horizon. If you cannot overcome your emotional hesitancy here, then consider converting some of your IRA or over a period of years.
Of course, a financial professional is knowledgeable to help guide you with decisions regarding your own personal circumstances.
Conversions to a Roth IRA are generally fully taxable. Before you convert to a Roth IRA, consider how your tax bracket will affect the overall benefit of the rollover. Conversion income may push you into a higher tax bracket. It is, however, possible to convert only part of your traditional IRA. This could enable you to remain in the same tax bracket you would be in without the conversion.
It is generally advisable to pay the taxes on the conversion with funds other than those in your traditional IRA. If you are under age 59½ when you do a conversion, any funds not deposited in the Roth IRA will be subject to the 10% federal income tax penalty (unless an exception applies).
Prudential Financial, its affiliates, and their licensed financial professionals do not render tax or legal advice. Please consult with your tax and legal advisors regarding your personal circumstances.
The opinions and recommendations herein are subject to change without notice and do not consider individual client circumstances.
The Prudential Insurance Company of America, Newark, NJ.
This advertisement provided courtesy of Prudential For more information, contact Joseph McManus, Financial Advisor with The Prudential Insurance Company of America’s Greater New England Financial Group located in Marlborough, MA Joe McManus can be reached at Joseph.McManus@Prudential.com and (508) 382-4904 Offering investment advisory services through Pruco Securities, LLC (Pruco), doing business as Prudential Financial Planning Services (PFPS), pursuant to separate client agreement. Offering insurance and securities products and services as a registered representative of Pruco, and an agent of issuing insurance companies. 1-800-201-6690.
1011277-00001-00, Ed 10/2018, Exp 10/18/2020
