With the market down nearly 24% from the beginning of the year (as of this writing in October 2022) many advisors and tax planners are asking their clients to consider a Roth IRA conversion. In most cases, this is excellent advice. Federal tax brackets are at historically low levels; the Federal tax rate was as high as 94% in 1944. However, with any financial advice, consider your unique situation, especially if you are a US citizen living abroad or are in a higher federal tax bracket.
What is a Roth IRA?
Roth IRAs are funded with after-tax dollars, and qualified withdrawals are tax-free. You won’t receive a tax deduction now, but the money grows and is withdrawn tax-free at retirement. This is ideal if you are in a lower tax bracket (10% — 24%) and expect your income and tax bracket to increase in the future.
What is a Roth IRA conversion?
A Roth conversion is the process of moving funds from a Traditional IRA to a Roth IRA. Since a Traditional IRA holds pre-taxed income and a Roth IRA holds income that has already been taxed, the conversion generally triggers an ordinary tax event.
*Please note that if you are executing a Roth IRA conversion while you are a U.S. citizen living abroad you will be subject to a 10% minimum withholding rate that you cannot opt out of. This policy may vary by custodian, so please confirm this before execution. If you are subject to mandatory withholding you should “top-up” the account to cover withholding to ensure you convert the full balance. When you file your return, your final ordinary income rate will be determined and could be between 0%-37% (2020).
Reasons to consider a Roth Conversion in 2022
· Down market (when the market is down you transfer a smaller balance, so you will ultimately owe less in taxes)
· Reduced income in the current year/ planned gap year
· Lower total tax bracket with a planned relocation back to the US & potentially higher total tax rate (Federal + State tax)
Any of the above factors may put you in a lower tax bracket. Accelerating income with a Roth conversion in the lower Federal tax rates of 10%, 12%, 22%, or 24% will mean potential tax savings at retirement.
Advantages of a Roth IRA
· Early withdrawal rules are much more flexible with a Roth
· Fewer restrictions for retirees- there is no required minimum distribution
· Distributions from a Roth IRA are tax-free
Disadvantages of a Roth IRA
·Pre-pay US tax
·Potentially included in foreign wealth tax assessment on an annual basis
· Your foreign country of residence may treat the Roth IRA as a regular investment account
Depending on where you live, your age, filing status, and earned income a Traditional IRA may be more advantageous to you.
If you are overseas, it’s essential to understand what you are eligible for and the most tax-advantageous option. Questions? Feel free to reach out to me, Arielle Tucker. I specialize in holistic, fee-only financial planning for Americans in Europe.