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ACM Journal - Investment Management
20 Jan

Chris’s Corner – Q4 2020 Newsletter

Roth IRA Conversion

To convert, or not to convert, that is the question. While Hamlet dithered over trivial questions about life and death, the consideration of how to optimize the tax efficiency of your IRA is far more interesting and important, but it can also be just as tricky.

One way to minimize taxes is to consider converting some or all of your IRA to a Roth IRA. Reasons to do so include:

Tax free withdrawals after 59½

When you take withdrawals from your traditional IRA you are required to pay ordinary income taxes on the total amount distributed (sans any portion that you contributed with post-tax dollars). Conversely, all distributions from Roth IRAs, as long as you meet certain requirements, are tax free.

No required minimum distributions (RMD)

Unlike with traditional IRAs, there are no RMD requirements with Roth IRAs. This allows for your money to grow tax free for a longer period.

Tax free inheritance

Your beneficiaries who inherit your Roth IRA will have to take RMDs, but they won’t pay taxes on the distributions, as long as the account has been opened for at least five years. Even if the account has been opened less than five years, only the growth or earnings portion is taxable; your principal may be withdrawn without taxes.

The inheritance issue has become even more important after of the passage of the SECURE Act in late 2019 that discontinued the stretch option for inherited IRAs. The new rules require beneficiaries to withdraw the inherited assets within 10 years. If you’re in the “classic” retirement situation where you’re living off Social Security, portfolio income, and maybe a pension, your RMDs and other IRA distributions are likely being taxed at a reasonable rate. Now fast forward to the date that your beneficiary inherits your IRA. Again, in the classic situation your child/children are now in their peak earning years and the money you just left them must be distributed over the course of 10 years. Both your savings and the money they are earning could now be subject to taxes at a higher rate.

The unfortunate fix to this is to start thinking again about death and taxes, and to determine if it makes sense to start distributing more money now at a lower rate or leave a larger balance that could be taxed at a higher rate. If you are in a low bracket and have successful beneficiaries, then the determination is easier.

Even if you’re not concerned about your beneficiary’s tax issues, there may be an opportunity to improve your own tax situation, particularly if you’re already retired and aren’t collecting social security yet. At age 72 you are required to take RMDs from your IRAs. The rates, and likely amounts, based on the IRS’ Uniform Life Table, will continue to increase as you get older and can end up pushing you into higher tax brackets down the road. It can therefore make sense to distribute assets out of retirement accounts before RMD time at a lower rate in order to minimize future taxes.

Generally, the biggest downside when thinking about Roth conversions relates to how to fund paying the taxes now and suppressing the mental accounting around having a smaller post-tax portfolio. We recognize everyone’s situation is unique and are happy to talk through if it makes sense for you.

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