Roth conversions provide a unique planning opportunity for certain investors looking to minimize their future tax liability. Below, we will discuss the following:
- What is a Roth IRA?
- What is a Roth conversion?
- When does a Roth conversion make sense?
- Mistakes and common errors
What is a Roth IRA?
Above, we can see that the primary difference has to do with when you pay taxes:
Contributing money into a traditional IRA will reduce your current tax bill this year assuming your income is within a certain range. This simply defers your future tax liability on that income to later years when you are retired. Contributing to a Roth IRA has no impact on your current tax bill but reduces your future tax liability since qualified distributions are completely tax-free.
What is a Roth IRA Conversion?
We complete a Roth conversion by simply transferring funds from a traditional IRA into a Roth IRA and paying the tax due on the conversion amount this tax year. Remember, money that goes into a Roth IRA is post-tax so we would owe taxes on the amount converted based on our marginal ordinary income tax rate for the year.
When a Roth Conversion Makes Sense
Now that we know what a Roth IRA conversion entails, we can begin to look at why we would do a Roth conversion and when it makes the most sense. We can see from the prior graphics that a Roth conversion is like a prepayment on your mortgage. You pay more money today but less interest (taxes) over the lifetime of the mortgage.
One of the big advantages of Roth IRA’s is their avoidance of RMDs once a retiree reaches age 72 under current law. Each year after, the IRS will mandate that the account holder distribute a certain percentage of the account each year and these distributions flow through to your tax return as ordinary income. The real pain is felt for taxpayers when the added income from the IRA distributions pulls more of their Social Security into taxation. Remember, your Social Security benefit is subject to Federal Income tax if your combined income is above a certain threshold as shown below:
By converting funds from a traditional IRA into a Roth IRA between the time you retire ($0 of earned income) and file for Social Security benefits, you reduce the amount of assets you have in your Traditional IRA when you hit the RMD age. By reducing the amount of assets inside your traditional IRA, you effectively reduce your RMD amounts each year going forward which lowers your ordinary income. Remember, your ordinary income increases the amount of tax you pay on your Social Security benefits so by converting dollars into a Roth IRA before you file, you may end up keeping more of your Social Security benefit down the road.
Let’s look at a sample client within our planning software to visualize how a Roth conversion can add value by reducing future tax liabilities.
Frank (58) & Joanna (57)
Retirement at age 65
$325,000 in current annual income
Frank has $250k in a Traditional IRA and $50k in a Roth IRA
Joanna has already converted her IRA into a Roth IRA
We will simply convert $25,000 from Frank’s Traditional IRA into his Roth IRA each year going forward until his IRA assets are entirely inside a Roth. Below we can see how their income tax is currently high during the last few working years they have followed by a large drop right after retiring since they no longer have a salary & bonus.
Highlighted in yellow, once they reach the age for taking required minimum distributions their overall tax bill each year is greatly reduced under the Roth conversion scenario. As they draw down their taxable and tax-deferred assets to fund their retirement in the early years, they eventually end up with all remaining assets inside their tax-free Roth IRAs to fund their retirement. An added benefit is that under current tax law, the Roth IRA assets will pass on to their heirs and retain their tax-free status.
Estate Planning Benefit
This is another added benefit of Roth IRAs vs. Traditional IRAs. When children (excluding qualified beneficiaries) inherit their parent’s IRAs, they must distribute the funds within a 10-year period under the current tax law. Unlike other capital assets that receive a step-up in basis at death, investments inside an IRA fall into the ordinary income bucket for inheritors. The required distributions are ordinary income for the beneficiary and given the average age difference between generations and life expectancies, often we see that the 2nd generation must withdraw inherited IRA assets during their highest income earning years (between age 50-65). By converting funds from Traditional to a Roth, taxpayers can minimize the size of their estate if they’re subject to estate tax and provide a tax-free asset to their children.
Roth Conversion Mistakes & Common Errors
- The Pro Rata Rule
Investors who have both pre-tax and post-tax dollars inside their Traditional IRAs need to be cognizant of the IRS’ Pro Rata Rule. The IRS comingles these dollars into one group whenever you complete a conversion; hence, you cannot simply convert post-tax dollars out of your Traditional IRA into your Roth IRA with $0 tax due. The IRS will include the portion that is considered Pre-Tax which will count towards your ordinary income for the year.
- IRMAA – Medicare Insurance Premium
If you are currently on Medicare or will be on Medicare within two calendar years from now, you need to pay attention when doing a Roth conversion. Medicare looks at your Modified Adjusted Gross Income (MAGI) from two years prior to determine if you will pay a higher premium for parts B & D this year. Below is the tax bracket for the IRMAA adjustment:
You must be careful when converting dollars to a Roth since the increase in your MAGI could increase your Medicare premiums. The Medicare premium increases are not permanent and should be analyzed on a case-by-case basis to determine if the long-term value still holds for doing a Roth conversion even after triggering a higher Medicare premium thanks to IRMAA.
- Using converted dollars to pay the tax due before turning age 59.5
If you are under age 59.5, a non-qualified distribution from your Traditional IRA will be subject to the 10% early withdrawal penalty. When you convert funds to a Roth IRA, you must not use the converted dollars to pay the additional ordinary income tax due. The funds used to pay the income tax would be considered an unqualified distribution and would incur the 10% penalty tax.
- Net Investment Income Tax
Another factor to consider is the Medicare Net Investment Income Tax. Under current tax law, there is a 3.8% tax assessed against the lower of your net investment income or the amount you go over one of the below MAGI thresholds:
- Not meeting the 5-year rule
Each Roth IRA conversion is subject to a 5-year rule by the IRS. Any funds you convert into a Roth IRA must remain inside the Roth IRA before withdrawing or else you will owe ordinary income tax on the gains. There is a unique way to shorten this period since the IRS doesn’t count calendar days, simply the calendar year. In other words, if you convert $X on 12/31/2022 the IRS considers that as being done on 1/1/2022 so the actual time needed is just over 4 years.
Roth conversions are a powerful tool that can add tremendous value to a client’s wealth by reducing their overall future tax liabilities. Clients who fall into the “blackout” zone (time between retirement and Social Security enrollment) should pay special attention to this potential planning technique given their low earned income for these years.
Pay on the seed, not the harvest
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