Upon divorce, retirement accounts that existed during marriage are frequently divided through a Domestic Relations Order. After a Domestic Relations Order is signed by the parties, submitted to the court for signature, and filed as an official order of the court, it is then sent to the Plan Administrator for approval. Once the Plan Administrator approves the Domestic Relations Order, it then becomes a Qualified Domestic Relations Order, which is frequently referred to as a “QDRO.” The retirement account is then split, at which time both parties will own their portion of the retirement account as separate property. If the retirement account is a Traditional IRA, the split of the account upon divorce puts a lot of people who are not familiar with retirement accounts in an interesting situation because they have the option to convert their Traditional IRA to a Roth IRA.
The full or partial conversion of a Traditional IRA to a Roth IRA was first allowed by congress in 2010. This financial decision became increasingly popular over the years because many IRA owners wanted to reap the many benefits that come with having a Roth IRA rather than a Traditional IRA. In fact, there have been more than one million conversions and more than $75 billion in Traditional IRA funds that have been converted to Roth IRA funds since that time. Some of the many benefits of converting a Traditional IRA to a Roth IRA include moving the retirement funds into an account that provides tax-free growth, offers tax-free withdrawals, and the person who owns the account is not required to take payouts at a particular age. Additionally, Roth IRAs also yield income that does not raise reported income in a way that reduces other tax breaks, raises Medicare premiums, or increases the levy on net investment income. Traditional IRAs, on the other hand, also provide tax-free growth, but the withdrawals are usually taxed at ordinary income rates at the time of the withdrawal. Moreover, an account owner of a Traditional IRA who is 70½ years or older is required to take payouts that will deplete the account over time.
After a divorce, converting the Traditional IRA a person received in a divorce to a Roth IRA is a popular financial decision for many people. However, even though this is frequently a smart decision to make, it may not always be the best decision. There are multiple scenarios where converting to a Roth IRA is not necessarily in the account owner’s best financial interest. The following are some questions you may want to ask yourself to help you decide if you should convert your Traditional IRA to a Roth IRA:
Is your tax rate going down?
Generally speaking, it would not make sense to convert all or part of your Traditional IRA to a Roth IRA if your tax rate will be lower when you make the withdrawals. For example, if your federal tax rate is low one year because you are a student working part time, this would be a great time to convert because you will pay taxes on your conversion based on your current tax rate. However, if you are well into your career making substantial income and your federal tax rate is on the higher side, you may not want to convert that year because you will pay taxes on your converted funds at that higher tax rate. It is usually best to convert your IRA funds in years where your tax rate is lower, so you do not have to pay more money in taxes.
Do you have enough money in your checking or savings account to pay the taxes on the converted money?
If you do not have enough “outside funds” to pay the taxes on your converted money, you should probably hold off on fully or partially converting your Traditional IRA to a Roth IRA. The reason for this, is that paying the taxes with money from the IRA shrinks the account value, which results in a reduction in the amount that can grow tax free. Consequently, it is best to hold off on the conversion until you have the outside cash to pay the taxes.
Will you need the funds from the Traditional IRA soon?
Much of the benefit of a Roth IRA comes from leaving the account untouched and allowing the funds to grow for years. If you anticipate that you will need to take payouts from your IRA sooner rather than later, then converting the funds to a Roth IRA may not be the best financial option for you. It would be best to leave the Traditional IRA as is, so you do not lose money on the conversion.
Will converting your Traditional IRA to a Roth IRA substantially increase your income and affect a financial aid award?
Retirement accounts are frequently excluded when institutions are determining financial aid awards. However, income from a conversion would not be excluded. If the income you receive from converting your Traditional IRA to a Roth IRA will prevent you from qualifying for a financial aid award for yourself or your child, you should consider holding off on your conversion until you already receive the financial aid you need.
What does all this mean for you? Upon divorce, if you and your spouse obtain a QDRO and split a Traditional IRA in two, you should examine your option to convert your Traditional IRA to a Roth IRA. If you are fairly young, do not have substantial income, and expect your tax rate to be much higher when you are older, then converting your Traditional IRA to a Roth IRA may be the best choice for you. However, if you are older, earn quite a bit of income, and your tax rate is on the higher side, then maintaining your Traditional IRA as is may be the best option for you. If you are unsure or have questions, you should reach out to your CPA or financial planner to determine what would be best for your financial position and your future. There is no doubt that this decision should not be taken lightly, and you should ensure you make an informed decision.