Effective January 1st this year, the $100,000 modified adjusted gross income barrier for converting traditional IRA accounts to Roth IRA accounts was eliminated. Now that the floodgates are open and everyone can convert their traditional IRA’s to Roth IRA’s, if you haven’t done so already, should you jump on the bandwagon? While the potential benefits of tax-free withdrawals and not being subject to required minimum distributions (“RMD’s”) (See Year of the Conversion) are extremely attractive, there are several obstacles one must overcome before switching horses.
Before discussing these obstacles, which will be continued in next week’s blog post, it’s important to keep in mind that when contemplating a Roth IRA conversion, it doesn’t have to be an all-or-nothing event. You can, and it’s often preferable, to do partial conversions of traditional to Roth IRA’s over one or more years.
There are three scenarios, in my opinion, that are “show stoppers” when evaluating a potential Roth IRA conversion:
- Primary beneficiary of traditional IRA is a charity
- 100% of retirement plan funds are invested in an active 401(k) plan
- No source of funds for payment of Roth IRA conversion tax liability outside of retirement plans
Primary Beneficiary of Traditional IRA is a Charity
The first thing one should do when considering a Roth IRA conversion is to examine the beneficiary designation of the IRA account(s) to be converted. If the beneficiary is a charitable organization, it generally doesn’t make sense to prepay income taxes if there is a possibility that there will be a tax-free distribution of the IRA to a charity.
100% of Retirement Plan Funds Are Invested In An Active 401(k) Plan
Sometimes people will roll over inactive pension plans, including 401(k) plans, into a traditional IRA and then convert the traditional IRA to a Roth IRA. If you are an active participant in a 401(k) plan, short of borrowing or taking a hardship withdrawal from the plan if permitted by the plan, you are prohibited from taking distributions from the plan prior to attaining age 59-1/2 or separation from service.
No Source of Funds for Payment of Roth IRA Conversion Tax Liability Outside of Retirement Plans
Assuming that you aren’t one of the fortunate individuals who is able to do a tax-free Roth IRA conversion, after calculating the potential income tax liability attributable to your conversion, you need to ask yourself the following question: What will be the source of payment of the income tax liability attributable to your Roth IRA conversion?If you don’t have sufficient funds in checking, savings, money market, and other nonretirement investment accounts outside of your IRA to pay the tax attributable to a Roth IRA conversion, you aren’t a good candidate for a Roth IRA conversion.
When you incur income tax liability in connection with a Roth IRA conversion, you always want to pay the income tax from funds outside of retirement plans, including the traditional IRA being converted. If you elect to have income tax withheld from your traditional IRA being converted to a Roth IRA, in addition to reducing the amount of the conversion by the amount of income tax withheld, if you are under age 59-1/2, you will be subject to a 10% premature distribution penalty on the amount of withholding since it is considered to be a distribution from your IRA that is not converted to a Roth IRA within 60 days.
Paying the tax from other retirement plans is also self-defeating since the funds will no longer continue to grow tax-deferred, there will be a taxable distribution, and, to the extent that you are under age 59-1/2, you will be subject to a 10% premature distribution penalty on the amount of the distribution.
If the primary beneficiary of your traditional IRA account isn’t a charitable organization, 100% of your retirement plan funds aren’t invested in active 401(k) plans, and you have funds outside of retirement plans to pay the income tax liability attributable to your Roth IRA conversion, put on your running shoes and get ready to run the high hurdles in Clearing the Roth IRA Conversion Hurdles, the topic of next week’s blog post.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.