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Year-end Tax Planning and Roth conversions

On Behalf of | Sep 29, 2023 | Estate Planning

Nerdwallet reported in the first quarter of 2023, Americans held an average IRA balance of $109,000. If you have an IRA, now may be the time to consider converting it to a Roth IRA. As you approach year-end tax planning, it might be the best option in preparation for an approaching retirement.

However, you must first understand the limitations on tax-free withdrawals and how they may impact your plans.

The basics of a Roth IRA

The Roth Individual Retirement Account offers an attractive feature that sets it apart from traditional IRAs – tax-free withdrawals. You make contributions to a Roth IRA with after-tax dollars, so, unlike traditional IRAs where contributions are tax-deductible, Roth IRAs do not provide an immediate tax break.

Tax-free requirements

The primary requirement for tax-free withdrawals is time. To be eligible for tax-free withdrawals, you must be at least 59½ years old and have held the account for a minimum of five years. This five-year rule is often referred to as the “Roth five-year rule.” It starts counting from the first tax year in which you make a contribution to any Roth IRA account, not necessarily the specific one from which you intend to withdraw funds.

Exceptions to the rules

If you experience a disability, make a qualified first-time home purchase (up to $10,000) or your beneficiaries inherit the Roth IRA after your passing, they can potentially make tax-free withdrawals without adhering to the age and time restrictions. These exceptions provide flexibility in accessing your Roth IRA funds when needed most.

Rules for withdrawals

You can withdraw contributions tax-free and penalty-free at any time since you already paid taxes on them. After contributions, the next funds to become eligible are converted funds and finally, earnings.

Roth IRAs do not have mandatory minimum distribution requirements during the account holder’s lifetime. This sets them apart from traditional IRAs, which require withdrawals beginning at age 72. The absence of RMDs allows individuals to maintain tax-free growth within their Roth IRA for as long as they desire, offering a considerable advantage for estate planning and leaving a tax-free inheritance to beneficiaries.

When you have IRAs, you may have to make changes depending on your retirement plans. This may be the year to make the switch to a Roth IRA.