May 18, 2022 – By Frank Corrado, CPA, CFP®, RLP.
When and why you might consider a strategic Roth conversion.
A Roth IRA conversion allows you to turn a traditional IRA or 401(k) into a Roth. The value of the assets converted will draw tax, but future withdrawals would be tax-free. The US Treasury, facing government deficits of over $3 trillion, would be pleased with people converting their IRAs to Roths and paying the tax now. But classic tax advice, and the principle of the time value of money, tells us it is better to defer paying tax for as long as you can!
There are exceptions to this classic advice because there are “always exceptions.” We classify our clients as being in the “sweet spot,” performing long-term tax projections and planning analysis, often across generations, to validate the strategic decision. The following sets forth the financial conditions that would make a “strategic Roth conversion” worth considering:
- Your marginal tax rate (the tax you pay on the last dollar of income) will be higher in the future than it is today—the larger the spread, the more profitable the strategy.
- You have retired early, and you will pay tax at the lower tax brackets until the start of social security, a pension, or required minimum distributions from your retirement accounts.
- A significant percentage of your assets are in retirement accounts that have yet to be taxed but will place you in a higher tax bracket when you must satisfy your required minimum distributions (RMDs). This higher income will also expose you to premium surcharges for Medicare IRMMA (income-related monthly adjustment amounts).
- You can pay the conversion tax due from assets or liquidity other than the converted assets and paying the tax from converted assets significantly reduces the strategic benefits.
- Your beneficiaries are likely to pay tax on an inherited IRA at higher tax rates than you.
- Your beneficiaries are in different tax brackets, say a corporate executive and a struggling musician. You would minimize taxes paid by directing the traditional IRA to the lower tax bracket and the Roth account to the higher taxpayer.
- You have a potential estate tax liability and would be willing to reduce your taxable estate by paying income tax on a Roth conversion. This transaction would accomplish the same outcome as a non-taxable gift and an estate tax reduction strategy for your beneficiaries.
Why Now?
There are outside factors that make a Roth conversion especially appropriate in 2022:
- The recently enacted Secure Act eliminated the “stretch IRA,” a strategy affluent investors use to pass tax-advantaged assets to their heirs. No longer can non-spouse beneficiaries take money out of an inherited IRA over their lifetimes. The new law requires that most IRAs inherited by people other than spouses be withdrawn within ten years. A sizable retirement account inheritance will place the beneficiary under tax rate pressure on all his taxable financial transactions.
- Tax rates will increase. The tax reform passed by Congress in 2017 reduced marginal tax brackets but included a sunset clause that would revert brackets to the higher 2017 levels in 2026, in the absence of action by Congress.
- The stock market downturn presents a prime opportunity to convert IRA assets with lower valuations, reducing the conversion tax burden or keeping it the same but with more assets converted.
A few key things to remember for converted dollars to a Roth: Generally, the dollars converted to a Roth must stay in the Roth for five years (regardless of age) to avoid taxes and a 10% penalty. The timeline begins on Jan.1st of the year of conversion. In addition, if you do conversions at or beyond age 72, the RMD must come out before the conversion, and RMDs are not eligible for Roth conversions.
This strategy may seem disturbingly complex, which it certainly is. But for those in the “sweet spot,” reflect through all concepts, and consider calling us to corroborate the potential tax savings.