By Johanna Turner, CFP, CPA, a financial advisor on NerdWallet’s Ask an Advisor.
If you’re nearing – or in – retirement, have you crossed Roth IRAs off your list of options? By doing so, you may be overlooking valuable tax savings for yourself and future generations. That’s because conventional wisdom tells us to contribute to a Roth in low-income years and fill up our tax-deductible accounts as income rises. While that certainly makes sense, it tends to take the Roth option off the radar as we age.
Simply put, a Roth IRA is an IRA that you fund with after-tax dollars, meaning you don’t get a deduction when you put money in your account. A big benefit is that all growth is totally free of tax (subject to age and timing rules). However, there is another, often overlooked, advantage: money in your Roth is not subject to onerous Required Minimum Distribution (RMD) rules. This means that you are not forced to begin emptying the account when you reach age 70-1/2.
If you plan to leave your IRA to a younger generation, as many of our clients do, this is an enormous advantage. Why? Because your heirs will pay taxes at their highest tax rate on a traditional (pre-tax) IRA inherited from you. But distributions from a Roth IRA will be totally tax-free to them.
And here’s the best part: you can set up a Roth IRA even after you retire. It’s done by a process called “conversion”: you transfer money from your traditional IRA to a Roth and pay taxes on the amount you transfer each year. You can convert any amount you want – or all at one time. This process should be done with a financial advisor who is experienced at tax planning so that you can plan to minimize taxes and watch for other hazards, such as a rise in Medicare premiums, as you go along.
So can you save taxes, too? When a prospect recently set up an appointment and we reviewed her tax return, we saw that she had negative taxable income, which would continue for several years. She also had an IRA with a six-figure balance. By doing a series of planned conversions, she was able to move much of her IRA into a Roth, paying very little in taxes. The Roth will go to her son someday and she will be required to take out far less in RMDs at age 70-1/2. Both she and her son will come out winners!
There are two more benefits of conversions: first, they are taxed as retirement income, which is exempt in many states. And second, you get a do-over if you change your mind after you convert. That’s right, you have until October 15 of the year following your conversion to change your mind!
Even if you do pay taxes at conversion, the tax-free growth in your Roth can more than make up for it. Remember that if you plan to leave your Roth to a younger generation, your portfolio should be based upon an age-appropriate risk profile, not your own.
The rules for Roth IRAs and conversions are complicated. This is not a do-it-yourself process. But with proper planning and follow-through you and your heirs can be richly rewarded.