It’s hard to believe that Labor Day has come and gone and that the days are getting shorter and the nights a little cooler. That means it is not too early to start thinking about whether there are any year-end tax or financial moves that you need to consider. Unfortunately, when it comes to year-end tax planning, too many people wait until the last minute, and because they rush, they tend to make poor decisions. Therefore, while you have the time, now is when you should start the process of deciding whether there are any year-end moves that you need to consider. One move that many people should consider is whether they should convert a portion of their traditional IRA into a Roth IRA.
I’ve spoken about this many times in the past and it deserves repeating. I believe every year you should look at your situation and decide whether it makes sense to convert any of your existing traditional IRAs into a Roth IRA. The benefit of doing this transaction is that eventually when money is withdrawn from a Roth IRA it is withdrawn tax free versus taxable with a traditional IRA. In addition, Roth IRAs are not subject to required minimum distributions at age 70½. Not everyone should do a Roth conversion; however, many people should take advantage of it. The following are the rules I use to decide whether converting is a good financial move or not.
The first rule is that you must have the money to pay the tax on the conversion without touching the money you’re converting. When you convert a traditional IRA into a Roth IRA, you are going to pay taxes on the amount of money you are converting. Therefore, it is important that you have the money to pay the tax without touching any of the money you are converting. The second rule is that by converting into a Roth IRA, it will not put you into a higher tax bracket. You can use your last year’s return as a guide to determine how much, if any, you can convert without putting yourself into a higher tax bracket. My third rule is that you have to be able to leave the money that you have converted in the Roth IRA for at least five to seven years. If you meet these three criteria, converting makes sense.
Many people think that to convert your traditional IRA you have to be working; that is not the case. Anyone is eligible to convert money into a Roth IRA from a traditional IRA. However, for those of you who are over 70½ and are taking required minimum distributions, those distributions are not eligible to be converted. You can convert anything above and beyond your required minimum distribution.
If you are considering doing a Roth conversion remember, the transaction must be completed by the end of the year. Therefore, there’s still plenty of time to allow you to make an informed decision.
There is another year-end move that only applies for those of you who are over 70½ and taking required minimum distributions. As you know, when you turn 70½, you must begin taking from your retirement account. However, a strategy that many people should look at is to potentially donate your required minimum distribution or a portion thereof, to a charity. For those of you who are charitable in nature and will make charitable contributions, you may find that under the new tax law you are no longer itemizing your deductions, and thus your charitable contributions would not be deductible. If you’re in that situation and you still make charitable contributions, a better strategy is to use your minimum required distribution for those contributions. The benefit of this is that you would not have to pay tax on your required minimum distribution that you donate to charity. Therefore, even though you cannot write off your charitable contributions, you are still getting a significant tax benefit by not having to pay tax on your distribution. The key to this transaction is that the money must be transferred directly from your IRA into the charity. If the money is distributed to you and you write the check to the charity, you would have to pay tax on your required minimum distribution. Therefore, for those of you who are over 70½ and are charitable in nature, if you have not taken your required minimum distribution, you may want to consider distributing that money or a portion thereof to charity.
Just like with the Roth conversion, this transaction must be completed by the end of the year.
It may seem like December is a long way off, but we all know how fast time goes. Therefore, it is not too early to think about year-end tax moves. In that regard, remember when you make year-end moves, the key is not to do what everyone else is doing, but rather, to do things that will make economic sense for you.
Rick is a fee-only financial advisor. His website is www.bloomassetmanagement.com. If you would like Rick to respond to your questions, please email Rick at email@example.com.