We are Roth Conversion fanatics at PARCO. Whether it be via our webinars, consultations, virtual seminars, or Facebook posts, we talk about it constantly. December is a critical month for this strategy, as the deadline to complete 2020 Roth Conversions is less than 30 days away. If you do not submit the paperwork by Thursday, December 31ˢᵗ, you cannot convert funds this fiscal year*.
As a refresher, a Roth Conversion is the process of converting funds from a Traditional tax-deferred IRA into a Roth IRA. Traditional accounts—like your Traditional TSP—are funded with pre-tax contributions, meaning dollars not yet subjected to income tax. By utilizing a Traditional account, you defer taxes while working, typically while in a higher income tax bracket, until a time like retirement, when you tend to be in a lower income tax bracket. Conversely, Roth accounts are funded with post-tax dollars. Once Roth account owners reach age 59 ½ (for IRAs), or separate from service on or after the calendar year they turn 55 (for the TSP)¹, and have had the account open for 5+ years (the “vesting requirement”), owners can access their entire Roth balance, both contributions and growth, dividends and interest, with zero tax consequences. We will say it here and say it again a thousand times, you will never pay income, capital gains, dividend, or interest taxes on funds in a vested Roth account.
Roth accounts are particularly useful for vastly increasing their owners' financial flexibility. Once age and vesting requirements are met, there is no amount you could possibly withdraw to jump into a higher tax bracket. Roth funds are also fantastic for any unexpected costs, systematic income, large lump sum purchases, and as a legacy planning tool for your heirs -- as they too will not owe taxes on any Roth funds bequeathed to them.
While there are annual limits to how much you can contribute to Roth 401(k)s and IRAs, there is no limit to how much you can convert into a Roth IRA, nor does an earnings test apply. In a Roth conversion, you convert a portion of your traditional IRA into your Roth IRA, paying the requisite taxes, while the remainder funnels into your Roth IRA. The amount you convert should be based on the amount of “room” remaining in your current tax bracket. To accomplish this correctly, you must determine your Adjusted Gross Income (AGI) and taxable income for the year. Always consult your tax professional to discuss whether you should pursue this, and precisely how much to convert. We at PARCO are very familiar with the conversion process, and can help you fill out the necessary paperwork in a matter of minutes.
Good candidates for Roth conversion tend to be those already retired as well as those who anticipate their income tax brackets to rise during the next Administration. At this time, the TSP does not allow participants to convert traditional TSP funds into either the Roth TSP or a Roth IRA. However, you can easily bypass this at retirement or age 59 ½ by rolling over your TSP into a Traditional IRA and then converting into a Roth IRA from there. At the very least, you should open a Roth IRA before the end of the year if you haven’t already done so, even if you contribute only a few dollars. This is important due to the mechanics of the 5-year vesting requirement, which looks at tax years, not calendar years. This means contributions made in December 2020 count the same, from the perspective of the vesting requirement, as contributions made January 1ˢᵗ of 2020.
To learn more about the Roth conversion process or to receive paperwork assistance, reach out to us; we're here to help.
*Tax rules are complex, change frequently, and vary by individual. Always consult your tax professional.
¹Phipps, Melissa. “What Is the Rule of 55?” The Balance, Dotdash, 24 Apr. 2020, www.thebalance.com/what-is-the-rule-of-55-2894280.