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MORE ABOUT IRAs

My blog, Traditional or Roth IRAs, covered the basics of contributions to and withdrawals from both Traditional and Roth IRAs. Those are the accounts that you as an individual can use to save for retirement, in addition to any company sponsored retirement plan accounts. There are different rules for Roth IRAs than there are for Traditional IRAs. We covered some of those differences in that blog. The comparison of the two types of IRAs continues this week.

Roth Conversions

A Roth conversion is the process of moving all, or part of, the assets from a Traditional IRA to a Roth IRA. You will remember that Traditional IRA contributions are pre-tax and Roth IRA contributions are after-tax so the assets that are moved change tax status and are taxable, they are converted. Why would someone want to move assets to a Roth IRA knowing they must pay income tax on the amount that is converted?

There are features to Roth IRAs that make them attractive to some investors. First, any growth or earnings, once converted, may be tax free when withdrawn. Depending on your tax situation, it may be beneficial to pay taxes now instead of in the future. Here is a list of possible reasons to convert from yahoo! finance:

  • The taxable income generated by a Roth conversion can be offset by other losses.
  • If asset values within the retirement plan are down, a Roth conversion will subject a lower amount of income to taxation.
  • If [you expect] tax rates [will] go up in the future, a Roth conversion at this time may be wise.
  • There are no required minimum distributions for a Roth IRA. 
  • A Roth IRA is good if your tax bracket may be higher during retirement than now.

Let’s imagine that you have contributed to a Traditional IRA annually for the tax deduction. This year, however, your income dropped dramatically for some reason. If you can pay the income tax associated with a conversion from resources outside of the IRA, it might be a good time to convert part, or all, of your Traditional IRA to a Roth IRA, and you might be able to offset the taxable income with other losses.

You may move assets in-kind in a Roth conversion, there is no need to sell holdings to move cash. The market value of any assets converted is determined at the close of the day that they are transferred from the Traditional IRA to the Roth IRA, not the day you request the conversion. You will receive a statement from your financial institution with the value upon which you will pay tax. It is included with any other distributions from your Traditional IRA on a 1099-R for that tax year. You will also receive a tax form 5498 later in the year that reflects the converted amount. A 5498 is not filed with your taxes. Oh, by the way, make sure you take any required minimum distribution from your traditional IRA before the conversion.

Required Minimum Distributions (RMDs)

As you may recall from my previous blog, the big advantage to a Roth IRA is that usually no income tax is due on withdrawals. Not only are contributions withdrawn tax-free (you already paid income tax on them), but the growth and earnings may also be tax-free. Another big advantage is that there are no required minimum distributions from Roth IRAs. The IRS has already received income tax from you so there is no compelling reason to require you to take a distribution.

Traditional IRAs are another story because contributions were made pre-tax, and the government wants some payment—in the form of a tax—during your lifetime. Therefore, starting at age 72 (age 70½ if born before July 1, 1949), Traditional IRAs (also company retirement plans) have a required minimum distribution and the amount that you withdraw will be subject to income tax. The amount of tax you pay depends on your income tax bracket because the total distribution amount is considered ordinary income.

The minimum amount that you must remove from a Traditional IRA each year changes. It is based on a computation: the total market value of the Traditional IRA account on December 31st of the prior year divided by an age-related life expectancy value from IRS Publication 590-B, Appendix B, Life Expectancy Tables (https://www.irs.gov/forms-pubs/about-publication-590-b). Please note that the life expectancy values changed for 2022 distributions. You may be able to access the new tables via an online search, but the updated IRS Publication 590-B was not yet available at the time of this blog.

Remember that you can always withdraw more than what is required. If, however, you do not remove at least the required amount, you will be subject to a hefty tax penalty. You may have to pay a 50% excise tax on the amount not distributed as required. Typically, you must withdraw the required amount by December 31st but there is an extended period your beginning year, the first year you are required to take an RMD. For that year only, you have until April 1st of the following year to take your first distribution, but then you must also take the distribution for that calendar year so you would take two RMD distributions in one year.

Example: You turn 72 on August 30, 2023. The 2023 required minimum distribution from your Traditional IRA will be based on the market value of your account on December 31, 2022. Then you have a choice. You can take the required distribution any time up to April 1, 2024. However, the delay into 2024 means that you will have a second distribution required in 2024 before December 31st. The amount of the second distribution will be based on the December 31, 2023, market value. Every year after that the deadline for your RMD is December 31st and is based on the prior year-end market value.

There are different rules for some company retirement plans so make sure you check the IRS website or discuss your situation with a tax or financial specialist. Your company’s plan provider and the bank or brokerage firm holding your IRA assets should also provide information. 

Beneficiary Designations

A beneficiary can be any person or entity—such as a trust or charity—the owner chooses to receive the benefits of a retirement account or an IRA after he or she dies. An IRA owner can name multiple beneficiaries for one account and then must specify percentage allocations to each beneficiary. If you are married and participate in your employer’s ERISA covered retirement plan, such as a 401(k) or pension plan, your spouse must generally be the beneficiary of that company plan unless the spouse signs a waiver or consent form to allow a different beneficiary.

Assets other than retirement accounts may also carry a beneficiary designation, if so desired, and that might make sense, especially if you are a single person and own assets titled in your name only. For example, a “transfer on death (TOD)” designation may be added to bank accounts or taxable brokerage accounts. Check with the firm that handles your banking and/or investments and make sure that it is appropriate for your situation. Real property, such as your home, may also carry a beneficiary designation in the form of a beneficiary deed. It is wise to consult a legal, tax, or financial advisor so that you understand all the pros and cons before you make beneficiary designations or changes.

Inherited IRAs

Let’s imagine that your father recently passed away. He had both a Traditional and a Roth IRA. Your mother is the only beneficiary of the Traditional IRA, and you are the only beneficiary of the Roth IRA. You and your mother have different choices and rules to follow as beneficiaries. Your mother, the spouse of the deceased and an eligible designated beneficiary, has one set of options, and you, a non-spouse designated beneficiary, have another set of options.

The rules for if/when you must begin taking required minimum distributions and/or distribute all the account assets depend on your beneficiary classification:

  • Eligible Designated Beneficiary (spouse or minor child of the original account holder, or an individual that is disabled, chronically ill or no less than 10 years younger than the original account holder)
  • Designated Beneficiary (most other individuals)
  • Non-Designated Beneficiary (trusts and organizations)

The SECURE Act, which went into effect on January 1, 2020, came with several changes for inherited IRAs. If the IRA account holder died on or after January 1, 2020, and you inherit their IRA, you’ll now generally have 10 years after the account holder’s death to withdraw all the money. Otherwise, you’ll face a 50% penalty on any money remaining in the account. However, this rule does not apply to those listed above as eligible designated beneficiaries. They have other options.

There are additional nuances based on your exact relationship to the deceased, when they died, and their age at the time of their death. The best thing either one of you can do is to talk to both your tax and your financial advisor before you do anything. You do not want to create undesired tax consequences with decisions made too quickly.

By the way, make sure your father took his required minimum distribution for the year of his death, if it was required. If not, it must be taken before any distribution of assets to beneficiaries otherwise penalties could apply.

Roth Conversions, beneficiary designations, and inherited IRAs can be complicated. Please take your time and ask questions so that you fully understand your choices and their tax ramifications so you make informed decisions that will benefit both you and your heirs.

~Bev Bowers, CFP®

 

Legal Notice: This document is intended to be informational only. Beverly Bowers does not render legal, accounting, or tax advice. Please consult the appropriate legal, accounting, or tax advisor if you require such advice. The opinions expressed in this report are subject to change without notice. The information in this report is from sources believed to be reliable but are not guaranteed to be accurate or complete. All publication rights reserved. Use of this material is subject to the Copyright restrictions described on BevBowers.com.
Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the CFP® certification mark and the CERTIFIED FINANCIAL PLANNER™ certification mark in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.