If you have a traditional IRA or a traditional 401(k) plan that can be rolled over into a traditional IRA, you’re sitting on a potential gold mine. You might ask yourself how this is possible given the fact that (a) you generally can’t take withdrawals from a traditional IRA before age 59-1/2 without a 10% penalty, (b) withdrawals are taxable as ordinary income, and (c) you must begin taking minimum distributions each year beginning at age 70-1/2.
Transitional Opportunity Accounts
You should always think of your traditional IRA accounts as transitional opportunity accounts™, or “TOAs” for those of you who prefer acronyms. They have the ability to be upgraded to a much more powerful IRA known as a Roth IRA. Unlike a traditional IRA, Roth IRA withdrawals are tax-free and there are no required minimum distributions, or RMDs, during your lifetime.
But what about the cost associated with making this change otherwise known as a Roth IRA conversion? Isn’t the value of the funds converted from a traditional IRA to a Roth IRA taxable as ordinary income? Isn’t this the same tax treatment that occurs when you eventually take withdrawals from your traditional IRA? Why should you prepay income tax that you might not otherwise pay for several years?
Great questions. Ignoring the opportunity to do a Roth IRA conversion following a stock market decline, there are circumstances that occur from time to time where your taxable income is less than normal. Either your income is lower and/or your itemized deductions are higher due to an aberration in your tax situation. When this occurs, your income tax liability on additional income is less than what it would be otherwise.
Look for Opportunities
Seven situations that are conducive for partial or full Roth IRA conversions, depending upon the specific facts, are as follows:
- Pre-age 70-1/2 retiree with low to moderate taxable income
- Large amount of long-term capital gains relative to other income
- Sale of rental property with large passive loss carry forward
- Sizable charitable contribution deduction
- Substantial basis in IRA
- Surviving spouse in low tax bracket not dependent on IRA with children in high tax bracket
- Net operating loss
The presence of each scenario presents an opportunity for analysis to determine if a Roth IRA conversion is appropriate, and, if so, the amount that should be converted from a traditional to a Roth IRA. The key is to be aware of each of them and keep them in mind if you have a traditional IRA or a traditional 401(k) plan that can be rolled into a traditional IRA.
Income Tax Planning is Essential
Unlike the deadline for traditional IRA contributions which is generally April 15th of the year following the year for which a contribution is credited, the Roth IRA conversion deadline is December 31st. If one of the seven Roth IRA conversion situations applies to you, you need to prepare an income tax projection well before year-end. The earlier in the year you prepare your projection, the better.
Your projection should include a base facts case calculating your federal and state income tax liability without any Roth IRA conversion. Additional cases should be prepared with different conversion amounts to determine the additional amount of income tax liability attributable to a potential conversion scenario. Remember to include cost basis attributable to nondeductible or after-tax contributions in your calculations, taking into consideration the value of all of your traditional IRA accounts.
The ability to spot, and take advantage of, Roth IRA conversion opportunities will be enhanced to the extent that you make it a practice to do income tax planning each year. Be on the lookout for the seven situations in this post and others. If the stock market has declined and your taxable income is lower than normal, it’s your lucky year. Don’t miss your Roth IRA conversion opportunity.
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.