Learn About Roth IRA Conversions & the Death of the Stretch IRA in this Video Blog Post
You’ve been hearing a lot from me about the Death of the Stretch IRA, and so might be happy to hear that the next couple of posts I do will concentrate on Roth IRAs and Roth IRA conversions. Is this because I want you to start thinking about your income tax planning for 2017? Not really – it’s because a series of Roth IRA conversions can, for some people, be the best defense against the Death of the Stretch IRA.
The Most Important Financial Fact About Retirement
If you’re new to my blog, though, I want to take a moment and emphasize what I believe is one of the most important facts that retirees should know about their finances. So here it is. Above all, you should understand that a positive financial outlook in retirement involves far more than just the rate of return you earn on your portfolio.
Surprised? One of my favorite illustrations that demonstrates this involves two hypothetical couples who are the exact same age, have the exact same amount of money when they retire and who invest their money exactly the same way. Everything about these two couples is exactly the same, except for one thing. One couple uses the optimal strategies when applying for Social Security and makes a series of Roth IRA conversions, but the other couple doesn’t. The illustration shows the scope of difference between the couple’s financial outlook during retirement. The couple who understood the most important financial fact about retirement invested in the exact same assets that the other couple did – so they did not earn a higher rate of return. But because they used the optimal strategies for Social Security and Roth IRA conversions, their retirement savings outlived them both and they passed a sizable estate on to their children. The other couple, unfortunately, went broke during their lifetimes.
Understanding the most important financial fact about retirement – that a secure retirement can depend on far more than just the rate of return you earn – can make a huge difference in your financial security.
The Benefits of Roth IRA Conversions
We’ve talked about how Social Security can give you a hedge against the Death of the Stretch IRA, so now let’s look at how Roth IRA conversions might benefit you.
What is a Roth IRA conversion? The simplest way to explain it is with an analogy. Suppose you are a farmer, and the IRS gives you a choice. You can deduct the cost of your seed and pay tax on your entire harvest, or you can forgo the deduction for your seed and reap your entire harvest tax-free. The second option shows the benefit of the Roth IRA. Would you rather deduct the contribution to your retirement plan and pay tax on withdrawals, or forgo the deduction so that you don’t have to pay tax on withdrawals?
In order to make a Roth IRA conversion, you have to enlist the assistance of the custodian who handles your traditional IRA. They transfer all or part of your traditional IRA to a Roth IRA and file some paperwork with the IRS. The paperwork tells the IRS that you owe them tax on the amount you converted, and that all of the money you earn in your new Roth IRA will be tax free. Some individuals are critical of Roth IRA conversions because you pay taxes before you’re legally required to. That’s very true. But even though nobody wants to give the IRS a helping hand, is there a benefit to prepaying the tax bill that will eventually be due on your traditional retirement plan? Let’s review the Roth IRA rules.
You know that Roth IRAs grow tax-free for the rest of your life. But did you know that they also grow tax-free for the rest of your spouse’s life, and under existing law, your children’s lives too? For those of you who aren’t all that motivated to leave your children in the best possible position because you think they should be happy with whatever you leave them, there’s another feature to the Roth that can provide an enormous benefit just for you. The Roth IRA rules specify that there is no Required Minimum Distribution (RMD) for the original owner or surviving spouse, as there is with a Traditional IRA. This benefit alone can provide you with enormous flexibility and control over your tax picture, especially after you turn 70 ½. Your children will be required to take RMD’s from any IRA that they inherit from you, whether it is a Roth or Traditional account. The difference is that the withdrawals from the Roth are tax free. That is beauty of the Roth IRA for your non-spousal heirs.
If you are concerned about your heirs, the tax-free benefit of the Roth will make all the difference after the Death of the Stretch IRA. This is because the Death of the Stretch IRA will accelerate the RMDs that your non-spousal heirs must take from the IRAs they inherit from you. The entire account must be withdrawn from the IRA within five years. And if you have a large IRA – $1 million or more – your children will have to take very large withdrawals. These withdrawals can potentially throw your children into a much higher tax bracket during those years, unless you had the foresight to convert your traditional retirement plans to a Roth.
We’ll talk more about Roth conversions next week. Stop back soon!
For more information on this topic, please visit our Death of the Stretch IRA resource.
P.S. Did you miss a video blog post? Here are the past video blog posts in this video series.