With all the recent changes to the U.S. tax code, it’s a good time to revisit different tax planning strategies. One strategy I’m often asked about is whether a Roth conversion is a good idea. The universal answer to that question is “maybe.” Unfortunately, there isn’t a simple rule of thumb that applies to everyone. There are many factors that need to be examined, and my goal is to tell you the most common reasons you might want to do a Roth conversion.
Before I do that, it’s important to note a particular change in our tax code with the passage of the Tax Cuts and Jobs Act (TCJA) of 2017. In the past, a recharacterization was done if you needed to “undo” the Roth conversion. Starting in 2018 and beyond, this is no longer allowed for Roth conversions. An exception is if you make a Roth contribution, and then learn that you earned too much income during that year. A recharacterization will still be allowed in this case so that you’re not subject to the excess contribution penalty tax.
Let’s start with the basics of what a Roth conversion is. An individual with a traditional IRA may decide to transfer some of those assets into a Roth IRA, and that’s done with a Roth conversion. Starting in 2010, income restrictions on Roth conversions were repealed, opening up the possibility of doing a conversion to millions of Americans. When you choose to convert a traditional IRA to a Roth IRA, you’re required to pay taxes on the pre-tax portion of the amount converted. There’s no “early withdrawal” penalty on that amount because you’re not actually withdrawing the money; instead, you’re converting it to a Roth IRA. With the current rules, anyone with a traditional IRA can convert a portion or the entire amount to a Roth IRA, and this might make it seem like a no brainer to start converting right away. It seems like a good idea, but it really only make sense for a few specific situations.
In most cases, you’re likely to benefit from a Roth conversion if you’ll be in a higher tax bracket when you begin withdrawing from the account. You can pay taxes now (at your lower rate) and then avoid taxes altogether when you’re at a higher rate. For most working individuals, it’s hard to make the case that they’ll be in a higher income tax bracket when they retire, which means a Roth conversion is probably not a tax-efficient move. But for people who are retired with a fixed, predictable income, a Roth conversion may ultimately be a benefit for their long-term retirement plan.
Let’s look at a couple of examples of when a Roth conversion could make sense.
Case Study #1: Retired before age 70
Joe & Jane are both 62 and they’ve decided to retire. They were each successful in their careers, and now they have a large portion of their retirement savings in their traditional IRAs. After careful planning, they’ve calculated how much they will spend each year. Also, Jane worked for a company that provides a pension, and they’ve made plans to delay taking Social Security until age 70, so they have an accurate estimate of what their annual income will be.
After consulting with their CPA and their financial advisor, they’ve decided to start making partial Roth conversions each year until age 70. By carefully examining their situation, they learned that their current fixed income puts them in a tax bracket that’s lower than when they were working, and they don’t anticipate increases to their income until age 70. At age 70, they’ll stop doing the Roth conversions because they’ll start receiving their Social Security benefit, and their required minimum distributions (RMD) from their traditional IRAs will begin at age 72. With all three sources of income (Jane’s pension, Social Security, and RMDs), doing a Roth conversion is much less tax friendly. Joe and Jane have made a plan to consult with their CPA each year to calculate how much of their traditional IRAs to convert to ensure they don’t do too much and accidently bump themselves into a higher tax bracket.
One final note: Joe and Jane must take into consideration that they need to be sure they can pay the additional income tax owed due to the conversion from an outside source that’s not the traditional IRA being converted. It’s crucial that they’ve accounted for the extra taxes and they plan on using their regular (taxable) savings to pay the additional taxes owed.
Case Study #2: A mid-career window of opportunity
Jennifer is 42, and she’s decided to take a job at a new company. She’s worked for many years as a successful sales rep, and a large portion of her annual income comes from commissions that are paid sporadically throughout the year. At her new job, Jennifer doesn’t know how long it will take to get her annual income back up to where it previously was. She does have a base salary, but that amount is much lower than her total income in years past. If all goes well, Jennifer hopes to be making the same or more in about 18 months. Jennifer knows that retirement is still at least 20 years away, but she has already accumulated a large retirement savings that is mostly in her traditional IRA.
Jennifer has a unique opportunity to take advantage of being in a lower tax bracket for a short amount of time. Based on her current situation, she anticipates earning less income for at least the next year, so she could consider converting a portion of her traditional IRA to a Roth IRA. In this situation, Jennifer should consult with her CPA and financial advisor to try and estimate how much she could potentially convert and still remain in a relatively low tax bracket. Instead of converting that entire amount all at once, though, she should space out the conversions every three or four months and monitor her income along the way. The risk is that if she converts the entire amount all at once early in the year, then unexpectedly lands a large commission sooner than expected, she could find herself in a much higher tax bracket than previously estimated. If she spaces out the conversions, she can review her income at the end of the year and make sure she has an accurate estimate of her situation. Remember, there’s no longer an “undo” option for Roth conversions, so it’s important that Jennifer gets it right on the first try.
As with our previous example, Jennifer needs to plan on how she will pay for the extra income taxes owed from the conversion. She needs to make sure she has enough money in her regular (taxable) savings to pay those additional taxes.
The two previous case studies are the most common scenarios on why a Roth conversion makes sense from a tax planning and retirement planning perspective. There are many other reasons to do a conversion, but it’s best to discuss detailing the possible optimization strategies with your financial advisor.
One final comment is a quick reminder on how much can change in the future tax code. The strategies outlined above are based on today’s current tax code, and the tax rules may be very different in years to come. As with all aspects of wealth management, it’s important to ensure your plan can evolve with the changes and that you have confidence in the professionals that you work with. If you’d like to learn more, or if you have any questions, please don’t hesitate to reach out.
IMPORTANT DISCLOSURES: No client or prospective client should assume that any portion of this article serves as the receipt of, or a substitute for, personalized advice from Merriman, or from any financial or tax professional. Merriman nor the author of this article are accountants. The client is responsible for determining whether any strategy discussed here is appropriate or suitable for them based on their financial and tax situation. The client or prospective client should consult with a financial advisor or tax professional regarding their specific financial or tax situation.
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