Introduce clients to the potential benefits of a Roth IRA
This content is categorized as:The Roth IRA can offer an advantage over other retirement vehicles. It provides for tax-deferred growth and tax-free qualified withdrawals.1 In addition to potential tax-free withdrawals, Roth IRAs do not have a required minimum distribution (RMD) while the Roth IRA holder is living. Finally, beneficiaries who inherit a Roth IRA that has been established for at least five years may be able to withdraw the earnings free of income tax. Jay Kautt, VP of Advanced Markets Sales, details below how partial conversions can offer control, flexibility, and long-term tax benefits for the right clients.
Roth IRA conversion rules you should know
Get expert insights on conversions, the pro-rata rule and 5-year timing rules.
Work Around Income and Contribution Limits
Roth IRAs have strict income guidelines that limit the number of individuals who can make contributions. In addition to the income guidelines, in 2025 Roth contributions are capped at $7,000 per year for those younger than age 50. If you are over age 50, Roth IRAs provide for an additional $1,000 鈥渃atch-up鈥� contribution. However, there are no income or contribution limits for a Roth conversion.
A Roth conversion is essentially a rollover of dollars from a traditional IRA to a Roth IRA. The amount converted is subject to income tax the year in which a Roth conversion takes place and conversions are tracked on a calendar year basis. Roth conversions are not an 鈥渁ll or nothing鈥� proposition. A partial Roth conversion allows the taxpayer to control the amount of additional income they are generating on an annual basis via the Roth conversion.
Evaluate the Tax Implications
There are several factors clients should consider prior to executing a Roth conversion. First, where will the money come from to pay the additional income tax due? Withholding or taking additional dollars from an IRA to pay the taxes creates two significant disadvantages. One, it increases the amount of income in that given year, thus increasing the amount of tax due. Two, if the taxpayer is under age 59 陆 that additional withholding from an IRA would be subject to the 10% early distribution penalty. Individuals who execute a Roth conversion may want to consider setting aside dollars from a non-retirement account to foot the tax bill.
A second factor to consider is an examination of tax brackets. Will income tax rates be higher in the future and what tax bracket does the individual anticipate being in? The income tax rates because of the Tax Cuts and Jobs Act (TCJA) may provide an opportunity to make Roth conversions now in a lower income tax rate environment.
A final consideration is how long until the individual needs the money? Ideally money is held for several years to allow for market growth to potentially offset the tax liability at the time of conversion. Two additional factors that need to be considered prior to making a Roth conversion are the pro-rata rule and the two Roth IRA 5-year rules. Each of those rules could have significant income tax impact on clients executing a Roth conversion and requires careful consideration. For more information on the pro-rata rule and Roth IRA 5-year rules, please see our whitepapers and Roth IRA conversion toolkit.
Identify the Ideal Client Candidates
Financial professionals should act now with their clients to determine if a Roth conversion is appropriate for them. The ideal candidates could be individuals who make too much money to contribute to a Roth and as a result have significant qualified assets in retirement. Other candidates may be those at or near retirement who need more tax-free dollars in retirement, are in a lower tax bracket, do not need the funds for a number of years, or want to create a tax-fee legacy in their estate.
Two final thoughts on Roth IRAs as you consider Roth conversions for your clients. First, Roth IRAs are excellent assets to leave to the next generation. As mentioned previously, assets in an inherited Roth IRA pass to the beneficiary free of income tax as long as the 5-year rule has been satisfied. For designated beneficiaries subject to the 10-year rule, inherited Roth IRAs do not have any annual RMD during the 10-year period. So, if the client who inherits the Roth does not need the money, they could let it sit in the inherited Roth for 10 years prior to liquidating. This can maximize the tax-deferred growth, and the withdrawal prior to the expiration of the 10-year period is a qualified withdrawal, free of income tax. Finally, a Roth IRA inside of an annuity is afforded the tax-free status of a Roth IRA. If a client is taking qualified withdrawals from a Roth IRA annuity and the annuity has an income rider, the rider payments are income tax free, even if the annuity account balance reaches zero.
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1 A 鈥渜ualified withdrawal鈥� is any distribution made after the 5-year tax period and one of the following apply: On or after age 59 陆, disability or made to the beneficiary or to the estate after death. First-home purchase with restrictions. A distribution that would otherwise meet the requirements of a 鈥渜ualified distribution鈥� will not be treated as a qualified distribution if such payment or distribution is made within the 5-taxable year period beginning with the first taxable year for which the Roth conversion contribution was made.
2 The actuarial present value of additional death and/or living benefits are considered, if applicable, in determining the fair market value (FMV) of annuity Roth IRA conversions within the same contract. The FMV is the contract value plus the present value of the additional benefits and is determined as of the date of the conversion. This is the amount that is reported on IRS Form 1099-R for the conversion.
