By: Andrew Rosen, CFP®, CEP®

If you are like most approaching retirement (or already in retirement) you likely have a substantial amount saved in an IRA or 401(k).  Most Americans dread knowing that the government is eagerly waiting for you to draw down these accounts.  They want all those tax dollars you’ve been avoiding for decades.  So the question is: how can you minimize taxes paid to the government for you,and your family’s, lifetime, while maximizing retirement income?  Converting Traditional IRA dollars into a Roth IRA is the single greatest solution to this common issue.

How a Roth IRA conversion works?

First, let’s understand the mechanics of how a Traditional IRA to a Roth IRA conversion works.  For our example, we’ll assume you have $200,000 in traditional IRAs.  What you can do is take any portion of that IRA and convert it to a Roth IRA.  Upon converting, you’ll be effectively paying all the taxes as ordinary income.  If you convert half this year, you’ll have a $100,000 Traditional IRA and a Roth IRA worth roughly $83,523 (assuming no State tax).  This would have you paying an effective tax rate of roughly 16.5%.  The IRA now grows tax deferred until you take money out, while the Roth IRA grows tax free.

The benefits for you.

Having these dollars grow tax-free can have a tremendous benefit on your financial planning. These dollars grow tax free for your lifetime and avoid any RMDs (required minimum distributions) at age 70.5 unlike its Traditional IRA counterpart.  Additionally, it provides you with flexibility as you begin taking distributions on your retirement accounts.  If tax rates increase, for instance, you can pull more dollars from your Roth IRA and effectively show no income.  When it comes to finances, having tax favorable dollars affords you options and a multitude of tax savings opportunities.

The benefits for your children.

The Roth conversion can have a tremendous legacy benefit.  Let’s compare the difference:

Traditional IRA

As you attain age 70.5, the government requires you take your taxable RMDs (whether you like it or not).  As you age, your required withdrawal percent increases.  Unfortunately, this amount creates a taxable event that is unwanted and unnecessary.

There are two option when a child inherits a Traditional IRA.  They can either take the entire thing out as a taxable event or designate it to be an IRA BDA (beneficial designated account). In an IRA BDA they can allow the corpus to grow tax deferred, while being required to take taxable distributions based off of their life expectancy.  For a 52 year old child, this would equate to 31 years of life expectancy and a year one withdrawal of around 3%.

Roth IRA

As a comparison, the Roth IRA can avoid many of these seemingly unavoidable tax issues and pass the net effect down to your heirs.  A Roth IRA is not subject to any RMDs.  While the Traditional IRA rapidly loses its tax advantages once you hit 70.5, the Roth has no such requirements.  Therefore, as long as you live, the Roth continues to compound tax free.

When a child inherits a Roth IRA the rules are the same as a Traditional IRA (where they can choose to take it out immediately or spread over their life expectancy).  There is one MAJOR exception:  these dollars now grow TAX-FREE for their lifetime. Let’s assume you are 55 years old today and live until 85. Your child is 22 and also lives until 85.  That equates to 63 years of tax free growth on your investment.  If you received a roughly 10% rate of return on your investments and left a $400,000 Roth IRA to your 52 year old child this equates to over $3,000,000 of tax free withdrawals!

The benefits for your grandchildren.

What if your child doesn’t need these funds?  If your child inherits a Roth IRA from you, they can opt to disclaim this account to their children (your grandchildren).  They effectively can make it a Roth BDA for your grandchildren, since their life expectancy is much longer (61.1 years on a 22 year old).  Assuming the same scenario from above (10% rate of return on a $400,000 Roth IRA), this would equate to over $33,000,000 of tax free withdrawals over their life time.  Talk about an amazing legacy to leave!  Remember, this is all from the bargain price of a one-time tax hit 9 decades earlier.

What now?

As you can see there are many benefits to a Roth IRA and Roth conversion that most people don’t realize.  I recommend planning your goals and objectives through retirement and beyond.  Help yourself (or have someone help you) formulate a carefully thought out plan of attack.

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Andrew Rosen

In his role as Financial Planner, Andrew forges lifelong relationships with clients.  He coaches them through all stages of life and guides them to better achieve their life goals.  For more information about Andrew or the other firm partners, Kyle Hill and David Levy, click the link below.

Find out more about Andrew Rosen, CFP®, CEP®
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