News & INSIGHTS

The Ins & Outs of Roth Conversions

By Patrick Swift | Vice President of Wealth Planning, Wealth Advisor

 

You may have heard the term “Roth conversion” thrown around in the past. Well, what is it? And is it something you should consider? When is it a good strategy?

Let’s start with the basics. Roth IRAs are often considered the “holy grail” of tax-advantaged retirement accounts.

Why?

While contributions to a Roth IRA go into the account after you have paid taxes on those dollars, they grow in the account tax-free. Unlike tax-deferred accounts, such as a pre-tax 401(k) or traditional IRA, the mouthwatering benefit of a Roth IRA is that withdrawals from the account are not taxable, no matter how well the investments have performed.

Besides favorable withdrawals, why else is this such a sought-after benefit?

Aside from the fact that once one’s income is too high they are barred from contributing to a Roth IRA, there are also IRS tax rules and estate transfer benefits to consider.

Unlike pre-tax retirement accounts, which require the account owner to take taxable withdrawals beginning at age 72 under current law, Roth IRAs do not.

Regarding traditional pre-tax retirement accounts and their IRS mandated withdrawals, if the account owner passes away, their heirs must continue those required taxable withdrawals until the account balance is exhausted. The rules for spouses and non-spouses are different, but they favor the former. If a non-spouse inherits an IRA, the account balance must be exhausted within 10 years per the SECURE Act, which was passed into law in 2019, thus diminishing a once-celebrated strategy referred to as a “stretch” IRA. This means non-spouse heirs pay taxes on those required distributions over that 10-year period.

Solution? Roth IRAs. Although it has been a longtime subject of Congressional debate, there is no required distribution from Roth IRAs for the account owner or a spousal beneficiary (conditions do apply). For non-spouse beneficiaries, the 10-year distribution rule applies, however, there are no taxes due on those distributions. That means when it comes to planning for inheritance and legacy, there are few better ways to tax-efficiently pass highly appreciated investments to heirs than through a Roth IRA.

So, what are Roth conversions?

Quite simply, a Roth conversion occurs when an account owner of a pre-tax retirement account (traditional IRA, 401(k), SEP IRA, etc.) converts all or a portion of their account balance to a Roth IRA. This triggers a penalty-free taxable event, and typically the entire conversion portion is taxable as income and subsequently added to adjusted gross income for the year.

So why add taxable income to your AGI if you are currently working and possibly in your peak earning years? Two reasons:

Taxes could go up. This is the real reason Roth conversions are a timely topic. Adjusted for the times, Federal tax brackets are amongst the lowest in our country’s history. Much speculation has been made around higher earners paying more in taxes through capital gains, higher income taxes, or both. Regardless of the current developments in Washington, it seems rational to think that taxes could be higher at some point in the future than they are today. As such, 2021 could be a great year to take advantage of lower tax rates and make Roth conversions.

Time to recap the tax impact. If an account owner makes a Roth conversion, regardless of how they pay the taxes, which I will discuss next, they will have a tax bill on money that otherwise would not have been taxed until much later in life. For the new tax-free Roth IRA account to accumulate a higher balance and justify the tax implications versus keeping the money in a traditional IRA, the account owner needs time for investment growth to compound.

Often people will retire before they take social security, leaving a gap window of a few years without significant taxable income, which would seemingly be a good time to make Roth conversions. However, that person’s life expectancy needs to be long enough to recap the taxes and accumulate a higher Roth balance.

Pre-retirement years present a potentially higher tax bill, but also more years to compound tax-free growth.

There are two other important items to consider when making a Roth conversion.

How to pay the taxes on conversion. As detailed above, because of the tax-free growth component, the more dollars in a Roth account the better. As such, it is unwise to “withhold” the taxes from the converted IRA balance. Instead, working with a tax professional to estimate what the tax liability will be, and paying that liability from cash or other non-retirement sources is the better route.

What state do you live in, and what state might you live in in the future? If you currently reside in a high-income tax state, this will create a higher tax burden on the converted dollars. If you plan to live in a low-income tax state in the coming years or in retirement, it could make sense to wait. On the other side of that equation, if you plan to live in a higher-income tax state in the future or in retirement, the conversion will make more sense today.

There you have it. The ins and outs of a Roth conversion. As always, please consult with the appropriate tax and financial professionals before making any decisions about your situation. Feel free to send an email to me or the Amplius team at AWA@ampliuswealth.com.