The current reduced tax rates are set to expire at the end of 2025.
There are a number of tax strategies that are worth exploring for the next several years before these reduced tax rates may expire. Many economists believe that the current lower tax rates are not sustainable given the ongoing federal government deficit, and that ultimately these low rates will need to be increased substantially.
There are several benefits of a Roth IRA over a traditional IRA.
Foremost among the benefits is that qualifying distributions from a Roth IRA are not subject to federal or state income taxes. This difference could therefore impact the taxability of other income sources such as social security or capital gains. The amount of social security benefits that are taxable is determined by the taxpayer’s taxable income, while the tax rate applied to capital gains is also determined by taxable income. In addition, since distributions from a Roth IRA are not taxable, they will not push a taxpayer’s income up into the next tax bracket.
Taxpayers want to pay as little income tax as possible.
Converting to a Roth IRA could allow a taxpayer to significantly reduce their income tax obligation in the long run by effectively paying the taxes up front on a smaller balance than when they subsequently withdraw the funds in retirement. The belief is that your retirement funds will grow due to investment returns and that when you make withdrawals at some future date you will withdraw more than the present balance within the account.
Converting to a Roth IRA will ensure that the taxpayer will have paid the taxes in full on those funds including any earnings growth that may occur. The resulting and ongoing balance in the Roth IRA provides flexibility that can be utilized during retirement as there will be no tax consequences associated with a distribution from these accounts. A distribution from a Roth IRA does not affect the taxability of other sources of income.
Another significant benefit is that, unlike a traditional IRA, there are no required minimum distributions that begin at age 72 from a Roth IRA. Some taxpayers who do not need take a distribution from their traditional IRA to meet living expenses would prefer to leave the money in their IRA where it would accumulate additional earnings but are required to take the RMD. Often this RMD is enough to move the taxpayer into the next higher tax bracket.
A third benefit to converting to a Roth IRA is that if you pass away, your heirs will inherit any funds remaining inside the Roth IRA tax free, as long as the Roth IRA has been opened for at least five years. An inheritance from a traditional IRA on the other hand would be subject to ordinary federal and state income taxes for the beneficiary when they make distributions.
I have had several clients over the years that I advised to convert some or all of their traditional IRA to a Roth IRA when they were younger who opted not to take my advice because they could not stomach the large one-time tax bill that occurs as a result of the conversion. Many years later when they turned 72 and were forced to begin making distributions from this tax-deferred investment, they regretted not taking my advice. In addition, the required minimum distribution amount continues to grow as the traditional IRA account holder ages.
A Roth IRA conversion may not be for all taxpayers, and it is indeed a big tax obligation to swallow in the year that a conversion may occur. The conversion does not have to be for the entire balance in one year but can be a portion of the traditional IRA balance staged over several years. Prudent tax and retirement planning may prove that paying the tax now on a smaller account balance at a lower tax rate may offer significant long-term savings as compared to waiting to pay the taxes on the traditional IRA distributions at a later date.
Paul Pahoresky is the owner of PRP & Associates. He can be reached at 440-974-1040 extension 214 or at paul@prpassoc.com. Consult your tax advisor for your specific situation for additional information and guidance on these topics.
