Much has been written about the benefits of converting retirement assets in a traditional IRA to a Roth IRA. During 2020, Roth conversions received a lot of favorable press with tax rates being low and the stock market being depressed for part of 2020.
This is a retirement savings strategy that might be beneficial for some of your clients, but like any financial strategy it should be looked at on a case-by-case basis to determine if it is a good fit for a particular client.
Here’s a detailed look at Roth IRA conversions to help you decide if this strategy is a good fit for your clients.
What Is a Roth IRA Conversion?
In a Roth IRA conversion, the account holder takes some or all of the balance in their traditional individual retirement account and converts that money to a Roth IRA. The money converted to a Roth IRA is taxable as ordinary income in the year the conversion is made. The exception is the value of any after-tax contributions made to the traditional IRA that are part of the amount converted.
Another possible type of a Roth IRA conversion might occur if your client is leaving their employer. A traditional 401(k) account can be rolled over and converted to a Roth IRA. The tax rules described above will still apply. Depending upon the rules of both the client’s 401(k) plan and those of the IRA custodian, an interim transfer to a traditional IRA may be required.
Once a Roth IRA conversion is completed, distributions from the account are tax-free as long as certain requirements are met.
Roth IRA Conversions, RMDs and Taxes
When considering a Roth conversion for a client, there are a number of issues to consider.
Notwithstanding the required minimum distribution waiver in effect for 2020, any RMDs for the year must be taken first, and the RMD amount cannot be converted to a Roth IRA. For example, if your client wanted to convert their entire traditional IRA balance to a Roth IRA, they would need to take their full RMD for the year prior to converting the rest of the account to a Roth IRA.
Generally, all assets converted from a traditional IRA account to a Roth IRA will be subject to taxes at ordinary income tax rates. The exception to this are any contributions made on an after-tax basis. Any gains on the investments in the account, regardless of whether the contributions were made on a pretax or after-tax basis, are also subject to taxes in a Roth conversion.
Where the client has traditional IRA money from after-tax contributions, pretax contributions and investment gains, calculating the amount of the conversion that is subject to taxes can become complex. This situation sometimes arises in the case of a backdoor Roth conversion discussed below.
It’s important to be sure that your client has sufficient cash outside of the traditional IRA to cover the taxes on the Roth conversion. If they need to tap their traditional IRA to cover the tax bill, these withdrawals will be subject to taxes and potentially to a 10% penalty if the client is younger than 59 ½. This could make the conversion quite expensive for your client and might lead you to suggest that the client forgo some or all of this conversion.
How Can a Roth IRA Conversion Benefit Clients?
A Roth IRA conversion can have several potential benefits for clients.
Roth IRAs are not subject to RMDs. For clients who don’t need the RMD income in retirement, this can result in tax savings each year. Additionally, this allows the value of the account to remain intact and potentially continue to grow over time. A Roth IRA can be a powerful estate planning vehicle for leaving money to a spouse or other heirs.
A Roth IRA can provide your client with tax diversification in retirement. This can be beneficial as we don’t know what direction tax rates will take in the future. At the time of this writing, we are on the cusp of a new presidential administration. Many speculate that President Joe Biden will look to raise taxes over the next few years. A Roth IRA conversion can act as a hedge against future tax rate hikes. Having retirement savings in both Roth and traditional retirement accounts can provide flexibility for your clients in helping them formulate a retirement withdrawal strategy.
In general, the decision regarding a Roth IRA conversion is often about your client’s current tax situation versus their anticipated future tax situation. With multiple income sources like pensions, withdrawals from retirement accounts and Social Security, it’s not uncommon for your clients to end up in a higher tax bracket in retirement than they were while they were working.
Roth Conversion Disadvantages
As with any financial strategy, a Roth IRA conversion is not the right answer for everyone. Here are some situations where a Roth conversion may not make sense, or at least where a careful analysis is required. Most of these types of decisions involve the merits of paying taxes now in exchange for the benefits of a Roth IRA at some point in the future.
When considering a Roth conversion, it’s important to look at the potential payback — specifically, the amount of taxes that will be due on the conversion upfront compared to the client’s life expectancy. This is especially crucial for a client who is 60 or older. An analysis needs to be run to analyze a potential break-even point where the benefits of doing the conversion, such as tax-free withdrawals and not taking RMDs, outweigh the current taxes due on the conversion.
Clients may want to do a Roth IRA conversion as part of their estate planning strategy. This is a prime example of where all of the pros and cons of the Roth conversion need to be weighed and discussed with your client. The estate planning benefits of the Roth conversion need to be weighed against the current-year taxes on the conversion.
Even for clients who are 59 ½ or older, the five-year requirement for qualified distributions remains in effect. In the case of Roth IRA conversions, there is a separate 5-year rule for each conversion that starts on Jan. 1 the year the conversion occurs. If your client will need to take a distribution from the converted funds prior to the completion of the 5-year window, any earnings will be subject to taxes, and if your client is younger than 59 ½ penalties as well.
The extra income generated from the Roth conversion could bump clients who are on Medicare into a higher cost bracket for their Medicare Part B benefits. For those receiving Social Security, the extra income may cause a higher percentage of their benefit to be subject to taxes in the year of the conversion.
Roth IRA Conversion Strategies
A Roth IRA conversion can be a versatile financial planning tool for your clients. Here are a few Roth IRA conversion strategies to consider, depending upon your client’s situation.
Doing a Roth IRA conversion when asset values in a client’s traditional IRA are low can provide them with “more bang for their conversion buck” so to speak. During the steep stock market declines we saw in March, many financial experts were touting the idea of doing a Roth conversion to take advantage of these lower valuations. A conversion under these circumstances allows your client to potentially convert a higher percentage of their traditional IRA, offering the potential for this depressed amount to appreciate tax-free in the Roth account over time.
Backdoor Roth IRA
The backdoor Roth is a popular strategy for those who earn too much to contribute to a Roth IRA. Here’s how it works: Your client makes an after-tax contribution to a traditional IRA and then immediately converts this to a Roth IRA. This method is simple and straightforward if your client doesn’t have any other money in a traditional IRA.
The backdoor Roth gets a bit trickier if they do have other money in a traditional IRA that includes pretax contributions and earnings. In this case, the amount converted will be taxed as a percentage of the after-tax contributions to the pre-tax contributions and earnings. An example might look like this:
- Client age 52
- After-tax traditional IRA contribution $7,000
- Additional assets in traditional IRAs from pre-tax contributions and earnings $100,000
Under this scenario, if your client converted the $7,000 to a Roth IRA, roughly 93.5% of the amount converted would be subject to taxes ($100,000 divided by $107,000).
Mega Backdoor Roth IRA Conversion
A variation of the backdoor Roth conversion is the mega backdoor Roth conversion. This is a strategy that can allow your client to contribute up to $38,500 on an after-tax basis to their employer’s 401(k) and then convert this money to a Roth IRA at some point in the future. This amount is reduced by any matching contributions made by their employer.
Your client’s 401(k) plan must allow after-tax contributions over and above the $19,500 or $26,000 (for those who are 50 or over) contribution limits. The maximum total contributions allowed to a 401(k) for 2021 are $58,000 and $64,500 for those who are 50 or over.
If the client’s employer allows in-service withdrawals, your client can roll the after-tax money to a Roth IRA doing the Roth conversion with little or no taxable income. An alternative, if their employer allows this, is to transfer the extra after-tax money to a designated Roth account within the 401(k) plan. The money is still in a Roth account where it can grow tax-free. When your client leaves their employer, they can then roll the funds in the Roth 401(k) over to a Roth IRA.
If their employer doesn’t allow in-service withdrawals then your client will have to wait until they leave the employer. In some cases their plan might allow participants to move this money once they reach age 59 ½. In either case this can still be an advantageous strategy, but your client will have to pay taxes on the portion of the Roth conversion that pertains to earnings on these after-tax contributions over time.
The Secure Act changed the rules for inherited IRAs for most non-spousal beneficiaries. With a few exceptions, non-spousal beneficiaries must withdraw the entire amount of the inherited IRA account within ten years of receiving it. In the case of a traditional IRA, this means paying taxes on the value of the account. In the case of beneficiaries who are adults in their peak earning years, this can be a large tax hit that was not anticipated by the account owner.
With an inherited Roth IRA, the same 10-year rule still applies. However, the distributions will be tax-free to the account beneficiaries as long as the account holder held the assets in a Roth IRA for at least five years prior to their death.
As mentioned previously, when considering this strategy it’s important to look at both the current-year tax consequences for your client and the overall tax situation at a family level.
A Roth IRA conversion is a powerful financial planning tool that may be appropriate for your clients. In fact many of them may be asking you about this tactic based on something they’ve read. There are a number of pros and cons to doing a Roth IRA conversion.
As with any financial planning strategy, it may be right for some clients but not for others. A Roth IRA conversion should be used strategically when and where it can be the most effective for a client.
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