A Roth IRA conversion may be a smart move. But time is limited.

There is no better time than now to consider converting some of your IRA funds into tax-free Roth IRA accounts. For a limited time there is an opportunity to save on income taxes, make it easier to tap into retirement funds, and transfer tax-free assets to your heirs.

What is a Roth IRA?

A Roth IRA is a retirement account that you fund with after-tax income–which means that unlike traditional IRAs, you pay taxes on the income now. Once done, all your future withdrawals will be tax-free, as long as you abide by some simple rules.

Close to 96 percent of the nearly $22 trillion in retirement accounts in the US is held in tax-deferred accounts like 401(k)s and IRAs, which can help lower your taxable income for the year. But you pay taxes on those funds when you withdraw from those accounts. Depending on your income bracket and current tax rates, you could pay higher taxes because those withdrawals are counted as income. If you take advantage of today’s lower tax rates, however, you can convert some of those funds into tax-free accounts like Roth IRAs. And when you withdraw funds from your Roth IRA later you will pay no tax on them.

The tax cuts signed into law under the Tax Cuts and Jobs Act (TCJA) lowered the tax brackets for most Americans. But these lower tax rates are set to expire January 1, 2026 and your tax rate will likely go up. If you can convert your tax-deferred accounts like IRAs and 401ks to tax-free Roth IRAs you can take advantage of today’s lower tax rates. Remember, when we say “tax free” it means you pay no taxes when you withdraw from a Roth because you paid the taxes on your contributions up front.

If you have recently retired, with retirement income in a lower bracket, this may be the best time to strategically shift funds from tax-deferred to tax-free accounts. Even if you are still working, and don’t plan to retire by 2026, the new lower tax brackets may still make it worthwhile to shift retirement dollars to tax-free accounts. Shifting funds into tax-free accounts now can boost your after-tax wealth later.

A long list of benefits

With Roth IRAs, you can save for retirement and enjoy tax-free investment returns, and tap into your funds if and when you need them. You’ll also enjoy important tax advantages: withdrawals are tax-free since taxes are paid when you fund the account. Withdrawals are also exempt from the required minimum distribution rules that apply to regular IRAs—particularly important if you are required to take large distributions that could push you into a higher tax bracket.

1. Savings grow tax-free

The main benefit of a Roth IRA is that your investments grow tax free. There are a few restrictions. First, for a tax-free and penalty-free distribution of investment gains, the Roth IRA must be at least five years old. In addition, you must satisfy one of the following conditions: reach age 59½, death, disability, or $10,000 of qualified first time home-buying expenses.

2. Withdrawals are tax-free

Qualified Roth IRA withdrawals are free of federal income tax and usually state tax as well. You just need to meet these requirements:

You’ve had at least one Roth IRA open for over five years.
You’ve reached age 59½ or have become disabled or have died.

For the five-year requirement, the countdown begins on the first day of the tax year for which you make your initial contribution to your first Roth account. For instance, if your first Roth pay-in was an annual contribution made on 4/1/18 for the 2017 tax year, the five-year countdown started on 1/1/17 (the beginning of the tax year for which you made the contribution) and you will satisfy the five-year requirement on 1/1/22.

It’s easier to tap into your funds

You can withdraw your contributions at any time without taxes or penalties. Although you normally must hold the Roth account for at least five years and be at least 59½ before you can tap the earnings tax-free and penalty-free, there are the exceptions we mentioned in our first point–death or disability of the account holder or use up to $10,000 to purchase a first home for yourself or certain family members. In addition, you can avoid the 10 percent early withdrawal penalty, but will still incur income taxes, if you withdraw earnings early to pay higher-education costs for yourself or a family member.

You can also pull out your own contributions to the Roth IRA. For instance, if you deposit $5,000 into a Roth IRA and its value grows to $10,000, you can withdraw your initial investment at any time without paying income taxes or penalties. This is because Roth IRA withdrawals allow you to withdraw your contributions first before having to draw on any investment gains. This is a considerable plus over a 401(k) or traditional IRA because withdrawals of contributions to deductible accounts typically generate income taxes owed and a penalty tax of 10 percent if you withdraw funds before age 59½.

Protect your Social Security from taxes

Large retirement account balances in IRAs and 401(k)s can trigger taxes on your Social Security. The IRS keeps track of ‘Provisional Income’ to determine if your Social Security will be taxed (Generally, up to 50 percent of your benefits will be taxable). Any distributions from your IRAs and 401(k)s go towards this Provisional Income. The IRS adds these distributions to 1099s you may receive from taxable investments and to 50 percent of your Social Security. If this adds up to more than $34,000 for a single person or more than $44,000 for a married couple, then up to 85 percent of your Social Security becomes taxable at your highest marginal tax bracket.

While we have long been able to convert traditional IRA accounts into Roth IRAs, recent legislation enables you to convert your 401(k)s as well. The only requirement is that you must pay the tax out of an account other than the 401(k) itself.
Even if you qualify for the tax benefits of a traditional IRA today, it doesn’t make sense to get a tax deduction today at historically low tax rates if your future tax rate will be higher.

Lower your taxes in retirement

Since Roth IRA withdrawals of both contributions and investment gains are income tax free when taken in retirement, they do not increase your tax liability, tax rate, Medicare premiums, or Social Security taxes.

No RMDs

You won’t need to take required minimum distributions (RMDs) when you turn 70½–in comparison to most other retirement accounts—and risk being pushed into a higher tax bracket. At that age, the IRS has a formula for the minimum amount you must withdraw from retirement accounts. This extra income can push some of your income into a higher marginal tax rate, make more of your Social Security taxable, and may result in having to pay higher Medicare Part B premiums. Add on higher rates after 2026 and you’re looking at more taxes. By comparison, a Roth IRA gives you more control to decide when to spend and allows your money to remain invested and to continue to grow tax-free longer.

Continue to save during retirement

If you decide to work once you’ve retired, you can continue to make contributions as long as you stay within the income limits.

Jump start retirement savings for your children

You can set up and fund Roth IRAs for children who may be in their early years of earning income but do not have enough extra money to fund an IRA themselves. While you need earned income to contribute to a Roth IRA, there are some limits on how much you can earn and still contribute. In 2018, for single filers, your ability to contribute to a Roth starts to phase out once your earnings reach $120,000 and are completely phased out at $135,000.

So you’re ready to make a move

Most major brokerage firms make it easy to convert to a Roth IRA. The simplest way is a direct trustee-to-trustee transfer from one financial institution to another. If you plan to keep your money at the same firm, tell them to redesignate your traditional IRA as a Roth IRA and skip opening a new account.

If you want to convert assets from your 401(k) or other employer-sponsored plan to a Roth IRA, make sure the money is transferred directly to the financial institution housing your Roth IRA. This is crucial. If your company issues the check to you, it is required to withhold 20 percent of the account balance for taxes. You’ll have just 60 days to deposit all the money in a new Roth account—including the 20 percent they withheld. Miss the deadline and any money not rolled over to a Roth IRA will incur a 10 percent early withdrawal penalty if you are younger than 59½—on top of the income taxes you will owe on the entire converted amount.

A last word on conversions. Once you’ve decided to convert funds from a traditional IRA or 401(k) account, there’s no going back. The new tax law has eliminated the option of changing your mind or ‘recharacterizing’ your Roth IRA and reverting back to a traditional account.

The time to act is now.

With many retiring or leaving the workforce long before RMDs begin, now’s the time to strategize your financial situation to boost your after-tax income in retirement.

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This discussion is not a substitute for professional financial advice. To help determine whether a Roth IRA makes sense for your individual financial situation, you should consult with a certified financial planner or your tax professional.

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