Should You Do a Roth Conversion? 3 Major Benefits

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One of the biggest tax mistakes retirees make is ignoring the impact that Roth conversions can have on lowering their lifetime tax bill.

A few months ago I wrote about the problem with having too much of your retirement assets in pre-tax accounts.

If most of your assets are yet to be taxed, that can pose a few issues:

-    You may think you have more for retirement than you actually do

-    The tax burden may surprise you if not carefully planned for

One of the best ways to address the problem of future taxes taking a bite out of your nest egg is doing a Roth conversion.

It means proactively converting pre-tax IRA assets to your Roth IRA now and paying taxes at your current tax rate.

It’s not a silver bullet tax strategy. This isn’t a hidden part of the tax code the IRS doesn’t want you to know about. You will have to pay taxes on the amount you convert to Roth.

But when done correctly, it integrates well into a complete tax plan and lowers the risk of unwelcome tax surprises.

In this article, we’ll look at three main benefits of doing a Roth conversion.

Roth Assets Are a Source of Tax-Free Income

Having flexibility is a great asset in retirement, especially when it comes to managing your distributions from retirement accounts.

If you only have pre-tax assets in your retirement nest egg, you have little flexibility. All withdrawals you take will be taxed at your ordinary income tax rate.

A well-built retirement nest egg combines three buckets:

1)   Pre-tax assets (yet to be taxed)

2)   Roth assets (already taxed, growing tax-free)

3)   Taxable assets (income and realized capital gains taxed at preferential rates)

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Contributions to Roth IRAs can always be withdrawn tax and penalty-free.

Withdrawals of earnings from Roth IRAs are completely tax-free, given

1)   The account owner is over age 59 ½

and

2)   The 5-year rule* has been met (more on this below)

*There are two 5-year rules dealing with Roth IRA withdrawals. The first 5-year rule states that it must be at least 5 years from the beginning of the tax year of your first contribution to any Roth IRA to the withdrawal of earnings. The second 5-year rule deals with Roth conversions – you must wait 5 years before withdrawing assets you converted to Roth. This penalty no longer applies once you reach age 59 ½ 😊.

With three tax-type buckets at their disposal, retirees can follow a withdrawal strategy that maximizes tax efficiency.

Examples:

• To generate retirement income, retirees may balance withdrawals from a combination of all three buckets to keep their marginal tax bracket low.

• If realizing large capital gains from a property or stock sale, taking withdrawals from a Roth IRA instead of a pre-tax IRA may keep the capital gains at a 0 or 15% tax rate and avoid the 3.8% Net Investment Income Tax.

• Taking withdrawals for retirement expenses from pre-tax IRAs up to the 1st IRMAA income threshold, then switching to Roth IRA withdrawals for the final months of the year can avoid higher Medicare premiums.

Reduce Future Required Minimum Distributions

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If you’ve only saved in pre-tax 401k or Traditional IRAs, you may have an unwelcome tax surprise upon reaching RMD age.

Now beginning at age 73, the tax code requires individuals to start taking annual distributions from their IRAs.

Unless you have after-tax basis in your IRAs, your distributions will be counted as taxable income. Large RMDs can result in unexpected taxes for retirees beyond the taxes already owed on Social Security and pension benefits.

To calculate the amount of your annual RMD, divide your year-end IRA balance by a factor based on your age.

A larger amount in your pre-tax IRAs means bigger RMDs. By converting assets to Roth, you reduce your balance in pre-tax IRAs and lower future Required Minimum Distributions.

Once the assets have been converted to Roth, there are no required distributions. The taxes have already been paid.

Create a Tax-Free Legacy For Your Heirs

Converting assets to Roth is instrumental in legacy planning.

Usually when I ask parents if they want to pay taxes on their IRAs so their children don’t have to, they’ll respond “No! Let the kids pay the taxes!”

To make that decision, however, one must understand what tax rules apply when your heirs inherit retirement accounts.

The SECURE Act in 2019 changed the rules on inherited IRAs and retirement plans.

It introduced a specific group of individuals called Eligible Designated Beneficiaries (EDBs). This includes:

• Surviving spouse

• Minor children

• Disabled or chronically ill individuals

• Beneficiaries not more than 10 years younger than the decedent

  
  

EDBs are allowed to take distributions from inherited IRAs over their lifetime, spreading out the tax bill that comes with distributions.

Every other type of beneficiary has 10 years from the account owner’s death to fully empty the inherited IRA.

If you have a substantial amount of pre-tax retirement assets, that can mean a significant tax burden for your children concentrated in only 10 years.

Instead of leaving a large amount of pre-tax assets as an inheritance, individuals concerned about the tax consequences will convert assets to Roth during their lifetime.

Once in Roth, neither the account owner nor the heirs will have to pay income taxes on future distributions. An inherited Roth IRA must still be emptied within 10 years of the account owner passing, but the distributions are tax-free.

In summary, having some assets in Roth eases the tax burden on your heirs:

• They won’t have to pay income taxes on distributions from the inherited Roth IRA, which may be substantial.

• No annual required distributions from an inherited Roth IRA except for full distribution by the 10th year.

• The amount in an inherited Roth IRA fully represents the funds available since taxes need not be factored in.

 

With the 3rd quarter humming along, it’s a good time to review your Roth conversion strategy.

At this point of the year, you probably have an idea of what your income is going to be.

Having an estimate of your income and tax bracket are important inputs to determining whether to do a conversion and how much you’ll want to consider.

A word of caution: don’t wait until December to start this process since many custodians have internal cut-off dates for guaranteed execution. Plus it’ll be the holidays and your loved ones will not be eager to discuss Roth conversions over the yule log.

Work with your CPA and financial advisor when considering a Roth conversion.

That’s all for now!

 

Travis

Investment advisory services offered through Andrews Advisory Associates LLC, a registered investment advisor. This blog is not meant to give investment advice. Before investing in any advisory product please carefully read any disclosure documents, including without limitation, the firm’s Form ADVs. The information herein is provided for informational purposes only, and does not constitute an offer, solicitation or recommendation to sell or an offer to buy securities, investment products or investment advisory services. Nothing contained herein constitutes financial, legal, tax, or other advice. These opinions may not fit your financial status, risk and return profile or preferences. Investment recommendations may change, and readers are urged to check with their investment adviser before making any investment decisions.