At the end of 2019, the Setting Every Community Up for Retirement Enhancement Act, or SECURE Act, was signed into law. The SECURE Act made changes to popular retirement vehicles such as 401(k)s, annuities, IRAs, and more. Due to some of these changes, Roth IRA conversions are more popular than ever. So, what is a Roth IRA conversion, and why is it more advantageous after the passage of the SECURE Act?
How is a Roth IRA different from a traditional IRA?
The biggest difference between a Roth IRA and a traditional IRA is when the funds are taxed. With a traditional IRA, contributions made to the account are tax-deductible while distributions taken during retirement are taxed. Roth IRAs are the inverse, meaning taxes are paid before contributions are made, but all distributions during retirement are tax-free. The other big difference between the two is while traditional IRAs have Required Minimum Distributions, or RMDs, Roth IRAs have no such stipulation.
What is a Roth conversion?
A Roth conversion allows you to take money from a traditional IRA and convert it to a Roth IRA. Doing so means you owe taxes on any money coming out of the traditional IRA. This includes the tax-deductible contributions you made as well as any tax-deferred earnings on those contributions. The most common way to convert funds is via a transfer, wherein you direct your financial institution to move money from your traditional IRA account to a Roth account. The other method is via a rollover, in which you take a distribution from your traditional IRA in the form of a check and then deposit those funds into a Roth account within 60 days. This method comes with extra risk, because if you fail to deposit the funds within the 60-day time limit you can be subject to a 10% penalty tax on early distributions in addition to the taxes you pay as a part of the conversion.
What are the benefits of converting to a Roth IRA?
Like most financial planning decisions, a Roth conversion isn’t the right option for everyone. Often people choose Roth conversions if they expect to be in a higher tax bracket during retirement than they are currently. This can be due to a temporarily lowered income level, or in anticipation of higher tax rates from future changes in tax legislation. People who plan to leave their retirement accounts to heirs can also benefit from Roth conversions. Since Roth IRAs don’t require RMDs, investments may continue to grow before they are inherited.
What did the SECURE Act change?
The passage of the SECURE Act is generating a great deal of interest in Roth conversions. This is due to new rules regarding inherited traditional IRAs. Previously, heirs could draw down the inherited account across their entire lives. Under the new rules, they must do so within 10 years of inheriting the account. This can come with a huge tax bill to the heirs, especially considering these accounts are often inherited during the time in their lives when they are most likely to be in higher tax brackets. Since Roth conversions have already been taxed, inherited Roth accounts don’t come with heavy tax burdens. Therefore, they have become a highly advantageous strategy to those planning to leave money to their heirs.