Roth Conversions are the topic du jour as we approach year end tax planning. This article looks at the benefits and costs of a conversion, including identifying the optimal windows and why they can be great tax management tools for both early and late career savers.
When asked, most people would choose to avoid paying any income tax before it is required. A Roth conversion requires that income tax be paid during that conversion tax year. Essentially, you are paying income tax earlier on this IRA withdrawal than you would if you did not do a conversion. Ugh. So why would I do a Roth conversion?
There are many benefits to Roth conversions. You are creating a pool of tax-free funds from which to draw in retirement. Sometimes it is easy to forget that traditional IRAs have an implicit tax liability built into them. For instance, if your IRA is valued at $1MM, remember that Uncle Sam owns a portion of the balance.
Using a Roth conversion as a potential estate-planning tool can also be a benefit. Your heirs will not be required to pay income tax as required when inheriting a traditional IRA. This is particularly beneficial to those bennies who are high income earners.
What is a Roth IRA?
A Roth IRA is an IRA with a special structure. Some of the traditional IRA rules are similar and others are very different. We always recommend that you speak with a financial adviser and/or tax planner to learn if a conversion is right for you. Be clear that a Roth conversion is not the same as a Roth contribution. Both are ways of funding a Roth IRA account, however, the rules pertaining to each are different.
6 Reasons a Roth conversion can be beneficial:
1. Roth growth and withdrawals are income tax free.
2. Many of us will be in higher income tax brackets when we start taking Social Security benefits, RMD withdrawals, pensions, etc. Prepaying the income tax when you are in a lower income-earning year may save money, depending on tax brackets.
3. Roth IRAs do not require minimum distributions. No RMDs. This is another way to control the tax bite in later years when income may be higher.
4. Current tax law is set to expire at the end of 2025, at which time tax levies will increase unless Congress acts.
5. Roth conversions can be an estate planning tool. For instance, an inherited traditional IRA may require income tax to be paid on withdrawals, depending on the beneficiary status. An inherited Roth IRA does not. Withdrawals by any beneficiary are tax-free.
6. The upfront income tax you pay reduces your taxable estate.
Now that you understand why someone would want to do a Roth, it is also important to know the following:
Important Roth Stipulations
• There is no limit to how much you convert, but you must pay the income tax on whatever is converted.
• When you make a Roth conversion you should have enough cash outside your IRA to pay the anticipated taxes. Most Roth conversions don’t make sense if you are using the IRA funds to pay your taxes.
• You can convert as much and as often as you like.
• If you are taking RMDs, that amount can never be converted to a Roth.
• Amounts in excess of an annual RMD can be converted.
• Roth conversions are permanent. They cannot be unwound or recharacterized.
• In order to remain penalty and tax-free, the amount of the conversion cannot be withdrawn for 5 years. Each conversion has its own 5 year clock.
When to do a Roth Conversion
For soon-to-be retirees or current retirees, the lower income years (usually prior to social security and age 72 when you begin taking RMDs) are typically the most optimal for conversions. For instance, if you retire at 60 and your income is lower than it will be before taking Social Security and/or IRA withdrawals, this could be an ideal time to execute a conversion or series of conversions.
If you are much younger (30s, 40s, 50s) and experience a job loss or a significantly lower income year, this could be a great time to do a conversion. A good advisor will point that out to you as an opportunity.
Be aware of the “stealth tax”
At age 65, when Medicare starts for most people, the monthly premium is determined by a Medicare specific form of MAGI of the prior two years of the Medicare recipient and where that falls within the Medicare IRMAA tax table. (IRMAA means income-related monthly adjustment amount.) It is a sliding scale of statutory percentage-based tables used to adjust Medicare Part B and Part D prescription drug coverage premiums.
The higher the modified adjusted gross income (MAGI), the higher the IRMAA.
Breaking through IRMAA thresholds is not a bad thing but it is certainly something of which to be aware. You are paying additional tax for a year or so in order to benefit from a Roth IRA which can accrue benefits for decades.
If you do decide to do a larger Roth conversion one year which bumps you into a higher tax bracket, you do have options to reduce your IRMAA in future years.
As mentioned above, Medicare looks at your MAGI from two years ago to determine your current year’s premiums. Once your income goes back to the lower threshold you can appeal to have your IRMAA bracket adjusted.
Request an appeal in writing by completing a request for reconsideration form. To get an appeal form you can go into a nearby Social Security office, call 800-772-1213, or check the Social Security website.
How much should I convert to a Roth IRA?
The truth is there is not always a “right answer”. Sometimes it is obvious; for example, if you happen to have a zero or very low-income year. At a minimum, you should take advantage of your deductions (standard or itemized) and then generate an income/conversion amount up to the 10-12% income bracket.
More often the decision is part art/part science. It is a combination of your appetite for paying additional income tax now or later, where you are within your marginal tax bracket, and how much room there is before you move into the next tax threshold. If you are receiving Medicare benefits, where you fall within the IRMAA brackets will matter as well.
Fortunately, we can model different conversion amounts and tax liabilities to illustrate potential benefits. We will also work carefully with your tax adviser to gain necessary information to make sure you are making decisions with the best information. Please contact Jenifer@mosaicfi.com to get more information.