For those with an Individual Retirement Account (“IRA”) Roth conversions may be a powerful financial tool that may help you optimise your tax planning and secure long-term financial benefits. In this article, we will explore the rules, strategies, and considerations for the effective implementation of Roth conversions.
A Roth conversion is a way to transfer funds from a pre-tax retirement savings vehicle (such as a Traditional IRA to a Roth IRA. While this process requires paying taxes on the converted amount at US ordinary income rates, it offers the potential advantage of tax-free growth and withdrawals in the future. By strategically converting in years when your income and tax rate are lower, you could potentially reduce the overall tax liability for you and your beneficiaries.
The underlying assets within the Roth IRA continue to grow free of tax within the pension account. Once you reach USA minimum retirement age (age 59 ½ under current legislation), any distributions from Roth IRAs are tax free. For UK residents, the tax treaty between the UK and the US ensures that this favourable tax treatment is recognised, meaning distributions are also exempt from UK income tax. Roth IRAs are also not subject to Required Minimum Distributions (“RMDs”) so you do not have to take withdrawals if the money is not needed and the assets can continue to accumulate tax free.
Almost anyone with a qualifying account can action a Roth conversion, but certain accounts, such as inherited IRAs, SIMPLE IRAs (within the first two years), and non-governmental 457 plans, are not eligible so it is always a good idea to seek advice from a specialist.
Pre-retirees can leverage several strategies to maximise the benefits of Roth conversions:
Backdoor Roth: contribute to a Traditional IRA and then convert it to a Roth IRA. However, be mindful of the IRA pro rata rule, which requires that when you convert traditional IRA funds to a Roth IRA, the amount converted is taxed proportionally based on the mix of pre-tax and after-tax (non-deductible) contributions in all your traditional IRAs. This means you cannot choose to only convert after-tax contributions tax-free; instead, each conversion includes both taxable and non-taxable amounts according to the ratio of pre-tax to after-tax funds across all your IRAs.
Low-income years: perform conversions during years with lower taxable income to minimise the tax impact.
Market correction: consider converting pre-tax accounts during market downturns, when asset values are lower, to allow future growth and recovery to occur within a post-tax environment.
Post-retirees can also benefit from Roth conversions through:
Systematic conversions: spread conversions over several years to fill lower tax brackets and reduce the lifetime tax bill.
Multi-generational 'Deathbed' conversions: convert assets to Roth accounts to minimise tax burdens for beneficiaries.
Estate planning: create strategically structured pots of money with varying tax treatments to optimise the inheritance outcomes for each individual beneficiary.
Timing is critical for Roth conversions. Factors such as marginal tax rates, income gaps, and potential "cliff" effects (where exceeding certain income thresholds triggers higher taxes or reduced benefits) should be carefully evaluated. Additionally, end-of-year conversions must be completed by December 31 to count for that tax year. Clients looking to retire outside of the US and the UK should seek professional tax advice on the treatment of Roth IRAs and conversions in their chosen country for retirement.
Funding the tax liability from a Roth conversion requires careful planning. Options include using extra cash, taxable brokerage accounts, or opting for the retirement account provider to withhold the relevant amount of tax. Using cash to pay the tax liability on a Roth IRA conversion is generally preferable because it allows your entire retirement account to continue growing tax-free, maximising future growth potential. Using funds from brokerage or retirement accounts to pay taxes could trigger additional taxes, penalties, and reduce your invested assets, ultimately diminishing your long-term retirement savings.
Once a Roth conversion is complete, it is essential to revisit your financial plans. Qualified distributions from Roth IRAs are tax-free if certain conditions, such as the five-year rule and age requirements, are met. Evaluating the pros and cons of Roth conversions is also crucial, emphasising benefits like lifetime tax savings and tax payment certainty.
Roth conversions can be a versatile tool for achieving tax efficiency and financial security. By understanding the rules, leveraging strategic timing, and planning for tax liabilities, you can make informed decisions that align with your long-term goals. As your wealth planner we can work with you in partnership with your tax professional to tailor these strategies to your unique situation.
To learn more about retirement saving options, please contact your Wealth Manager or the LGT Wealth Management US team here.
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