SEP IRA to Roth Conversions and Stretch Roth IRAs and RMDs

Updated : Sep 02, 2019 in Articles

SEP IRA to Roth Conversions and Stretch Roth IRAs and RMDs


We got Susan from San Diego. “Hi Joe and Al. My husband has money in a SEP IRA that he
was able to save when he had a small business years ago. He no longer has that business, just his regular
income which is reported on a W-2. As he cannot add any more savings to the SEP,
he was thinking about converting this to a Roth IRA this year. He will have to pay the taxes on the conversion
but is it possible for him to convert straight from his SEP IRA to his Roth? Susan, yes. The answer is yes. Absolutely. But you would want to be careful, I guess. I mean what’s the balance of the SEP IRA? What tax bracket are you in? Sure. You’ve gotta ask a few more questions, and
I think that’s a great question, because a lot of times when you’re reading or listening
to pundits that talk about, “you could do an IRA to Roth conversion,” you could also
do a SEP IRA to Roth conversion, you can do a 401(k) balance to a Roth conversion. You can take any retirement account and convert
it to a Roth IRA. And now it used to be that you could recharacterize
if you converted too much. You had until the filing date of your tax
return, and you had to recharacterize generally back to an IRA, regardless of where it came
from. But those rules are gone. So it’s very simple – whatever account you
have, it’s a SEP IRA, you can convert that directly to a Roth. The question is should you? What’s your tax bracket now, what’s it going
to be in the future? Maybe you’re in a low bracket, maybe you’re
in a high bracket. The lower the bracket you are, the more likely
you’re going to want to do a conversion now while tax rates are lower. Maybe you want to fill up your current bracket,
so maybe you don’t convert at all. Maybe you convert part of it. So those are things you’ve got to look at. Yeah. So again, to refresh our listeners on what
the heck a conversion is, it’s taking money – so a SEP IRA is just a self employment pension plan. So her husband, Susan’s husband, was self-employed
and set up a retirement plan for his small business. And so it was a pre-tax plan. So he got the tax deduction for money going
into the SEP, the money grows tax deferred. And then when he would pull the money out,
it’s going to be taxed at ordinary income rates. Susan is a big fan of the show. And so she’s like, “well wait a minute, maybe
it might make sense for him or us to have tax-free money in retirement.” So strategies that we’ve talked about in the
past is taking retirement accounts, any accounts for that matter, and moving some of that or
all of it into a Roth. The reason why you would want to do that is
that all future growth of that investment will grow 100% tax-free. So you convert $10,000, that $10,000 grows
to $15,000. Let’s say you need a pull of a few thousand
out to live on. That would be 100% tax free for you, as long
as you qualified for a tax free distribution, and that just means you have to be over 59
and a half or the Roth needs to be open for five years or longer. So what we look at, and what we talk about,
is that yeah, tax rates are a little bit lower now. We had the tax reform, so marginal rates have dropped. And so, it could be a really good strategy
for a lot of people to look at. So looking at your tax return is going to
determine how much that you convert. You bet. And so what we’re talking about, like for
example, a married couple, the 24% tax bracket goes all the way up to about $321,000 of taxable
income for 2019. Realize when you do a Roth conversion, you
have to do it in the tax year that you’re in. In other words, it’s not like a contribution
where you can do it April 15th. You have to do it by year end. So now we’re talking 2019. And so for a lot of folks it’s like, well
this is a lower bracket now than I’m going to be in retirement, because the old tax rates
are coming back and alternative minimum tax will be a bigger factor when it comes back. And so why not? And for single, that 24% bracket goes to about
$160,000, so that’s pretty good to take a look at that. I think virtually everyone listening should
be considering it. Now, whether they should do it or not is based
upon their own circumstances. And she goes on to write, “it would be very
beneficial for your listeners is you highly recommend everyone having a Roth IRA.” Susan, we do not highly recommend anything
on this show. We share ideas. We do not give advice. That’s compliance. “Thank you for all the great information you share.” OK, so she wants to learn a little bit about
a stretch Roth IRA. So let’s say that her husband then converts
the SEP IRA to a Roth IRA, and then the Roth IRA is growing tax-free and the husband dies. What happens to that money? So a few things can happen. Let’s say Susan is still living. She could keep it in the deceased husband’s
name and she has full access to the money like it’s her own, because she is the beneficiary. As long as she’s the beneficiary on the account. So she can keep it in his name. And let’s say Susan’s under 59 and a half,
she can have full access to the dollars. That’s the only real reason why you would
want to keep it in the deceased spouse’s name is that if you’re under 59 and a half and
you need access to it. Because if you are a beneficial owner of a
retirement account, you have access to those dollars without that 10% penalty. So it would still be tax-free to you Susan,
as long as that account was open for five years. If it wasn’t, you would still have to wait
for the five year clock to get any type of interest out of that account. Maybe you’re wondering what happens to that
account, and both of you are spouses, and let’s say you have a son or daughter that
is going to be the beneficiary of that account. So if it’s after the second spouse passes,
how it works is that it would still be in the deceased’s name. So to make this easy, let’s say her husband
passes, Susan puts the Roth IRA into her own Roth IRA, which she can, because they’re spouses. Now she passes away and it goes to her child. Now the child cannot put the Roth IRA into
the child’s account. It will blow the thing up. It would unravel everything and 100% of that
Roth IRA would be distributed. Then any future growth of those dollars are
going to be taxed at either a capital gains interest or dividend. So you don’t want to do that, especially if
you’re converting them and paying tax. You want to have it parlayed tax-deferred
as long as you possibly can. So you pass, Susan, it goes to your heir. And so what happens then is that it still
stays in your name though. That’s the biggest tricky part about all retirement
accounts going to the next generation, or any non-spouse beneficiary, I should say. So it would stay in Susan’s name for the benefit
of her issue. Which is “kid.” Which is child. (laughs) Or any beneficiary. Well he’s probably caused some “issues” in
Susan’s life. (laughs) Yeah. Just clarifying. (laughs) You got legal on us. (laughs) I read a book over the weekend. But here’s the catch with Roth IRAs. You don’t have to take a required distribution. If it’s your account, you do not have to take
a required distribution. What that is is that it’s a mandatory distribution,
age 70 and a half, thereafter you have to start taking money out of the account. In a Roth IRA you do not, as long as you’re
the owner of the account. Once you pass away though, you’re still the
owner of the account, the beneficiary is a beneficial owner. So it’s not a true ownership of that account. So that non-spouse beneficiary will have to
take a required distribution from the Roth IRA based on that child’s life expectancy. The distribution is tax-free, but they do
have to pull money out of the account based on their life expectancy. Yeah I think that bears a little repeating. So it’s still tax-free – when you do the Roth
conversion, what’s in that account is tax-free for whoever inherits it. But if it’s a non-spouse, if it’s a child
or nephew or friend, a non-spouse, then they have to take a required distribution. They could be eight years old and still have
to take a distribution based upon the eight year old’s life expectancy. And the reason is because the IRS doesn’t
want these accounts to grow generation after generation tax-free. And so in recent tax law, that did not pass,
what they want to do is eliminate, basically, the stretch IRA. Right. And we thought they would, because both the
Democrats and the Republicans wanted that. So they were saying, “No, this is a retirement account. We want you to distribute in your lifetime,
because it’s for your retirement, not your child’s retirement.” That’s right. Or if you die early, it’s got to come out
in five years. Right. Get the whole thing out. We want our tax money, let’s recycle the money. And so what the latest proposal was is that
you could pass about $450,000 – 400 or 450. That would be able to stretch. Everything else has to come out within five
years or that year. Yeah. And that was the proposal, which did not pass. Right. It didn’t pass so we still have the stretch. We still have the full stretch on regular
IRAs and Roth IRAs. And I mean, there have been rumors of, maybe
you can pass a million dollars. Maybe it’s 200, and maybe it’s 4, whatever. so stay tuned on that. But just know that if you ever inherit a retirement
account, you have to take a required distribution. We just had an individual that came in, inherited
an account, never took a required distribution for like three or four years. And they were with a broker, we’re like, “well
what did you tell the broker?” And then they’re like, “oh yeah, they’re gonna
run some numbers for me.” And I was like, “Well when did you inherit
this thing?” “Well, four or five years ago.” “And you’ve never taken an RMD??” I looked at the tax return – nothing. So that’s a 50% tax penalty each year that
you don’t take the RMD. When you’re looking at beneficial IRAs, it’s
completely different than a regular IRA. Most custodians, iIf you’ve got your money
at TD Ameritrade, Fidelity, Merrill Lynch, whatever, they usually will send you a letter
saying, “hey, we have your birth date here, you’re 75 years old. You need to take money out of this account. And here’s the amount, roughly, that you need
to take out.” And they’re just going to give you the number
on the accounts that they hold. So maybe you have an account at Fidelity. You have an account at TD Ameritrade and Charles Schwab? Maybe Charles Schwab doesn’t do it or forgets . And then you get the number from TD Ameritrade
and you only take that RMD? You’re gonna be short the RMD. Be careful with that. But non-spouse beneficiaries, a lot of them
don’t even calculate that – they don’t even know, they’re like, “Screw it. I don’t even know how much,” that’s on you. You are the taxpayer, you are responsible
for taking the required distribution. The custodian is not. They’re doing it as a service – as a customer
service perk. The IRS does not mandate Fidelity to send
you out a statement, for what I know. Right. Wow, you got pretty fired up. Well, I just don’t want people to lose money. I got a big heart, Al. (laughs) Apparently. You’ve got a big wallet. I’ve got a big… heart.

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