Under the new tax law, many individuals and couples will benefit from a lower marginal tax rate. This presents a number of planning opportunities for investors, particularly since the individual tax rates (and various other provisions of the Tax Cuts and Jobs Act) are set to expire in 2025 (if not sooner by a new administration.)
Although there are income limitations on regular Roth IRA contributions, all investors are permitted to make one Roth conversion per year.
With more favorable tax rates, high-earners are reconsidering whether a Roth conversion strategy fits into their financial plan.
With a Roth IRA, you pay tax now and (potentially) nothing later. A Roth IRA is a type of retirement account which is initially funded with after-tax dollars. The funds can later be withdrawn tax-free, subject to certain limitations. Your personal contributions can be taken out at any time tax and penalty-free, but there are some requirements to receive tax-free investment growth.
[See: 11 Steps to Make a Million With Your 401(k).]
Generally, as long as at least five years has passed since you began funding the account and you are age 59½ or older, investment earnings can be withdrawn tax and penalty-free. There are a few exceptions where withdrawals could still be made tax and/or penalty free, but for the purposes of this article, we’ll assume funds meet both the five-year test and 59½ age requirement.
There are income limits which prevent high-earning individuals from making regular contributions to a Roth IRA. However, these restrictions do not apply to a Roth conversion, which is permitted once per year for all individuals.
New tax brackets make Roth strategies more attractive. Since funds added to a Roth account are taxed during the same year as they are made, as your marginal tax rate increases, the benefits of the strategy decrease, all else equal. Under the new tax law, many taxpayers will benefit from an overall reduction in tax rates for the next few years.
For single filers, the new tax brackets are generally advantageous to those with taxable income approximately less than $200,000 and greater than $400,000. For married couples filing jointly, the new tax brackets will benefit nearly all taxpayers.
For high-earning investors, the temporary tax relief provided by the new tax law may offer a Roth conversion opportunity. When you convert funds in a tax-deferred account to a Roth account, the amount converted is included in your taxable income for the year. Assuming you have non-retirement funds available to cover the tax due, a Roth conversion allows investors to avoid paying income tax on this portion of savings and subsequent growth, which would presumably be at higher tax rates in retirement.
The retirement tax cliff. Most of us have the bulk of our retirement assets in tax-deferred accounts like a 401(k) or traditional IRA. While these types of accounts offer benefits, such as tax deferred growth, retirees with significant savings may find themselves in a much higher tax bracket in retirement.
Retirees with tax-deferred portfolios more than $1 million may fall victim to what is called the “retirement tax cliff,” referring to a sharp tax increase in retirement after age 70½ when required minimum distributions begin. RMDs are calculated using the uniform lifetime table which is distributed by the IRS. At a high level, to calculate your required minimum distribution, you would look up your age on the table and divide your account balance by the corresponding distribution period. For retirees with significant savings, this could mean taxable income well into six figures per person.
[See: Warren Buffett’s 8 Favorite Stocks.]
A Roth IRA conversion strategy can offer a unique solution to this potential problem. First, by converting tax-deferred dollars to a Roth IRA, your required distributions after age 70½ should be reduced. Second, there are no RMD requirements for Roth IRAs, leaving you complete flexibility to time your distributions or avoid taking them completely. Third, by having tax-diverse account types, you may have additional options to structure even more tax-efficient withdrawals in retirement.
Evaluating a Roth conversion. If you are considering a Roth conversion strategy, consider working with your financial advisor and accountant first to run an analysis and develop a strategy for your long-term retirement goals. Remember, there isn’t usually a yes or no answer to a Roth conversion question. There are a number of factors unique to an individual’s situation which can impact whether the strategy might be beneficial, including the actual amount to consider converting.
When developing a client’s financial plan, we can run a comparative analysis to help determine which strategy may be advantageous over the long-run. By considering all of the factors relevant to your finances, such as cash flows, taxes, investment returns, income needs, desired retirement age, and so on, we’re able to help illustrate the pros and cons of each strategy.
There are a variety of other planning caveats to consider, as well. Individuals close to retirement should consider whether recognizing the additional income will impact their Medicare premiums. Also, without a long-term plan, a one-off Roth conversion may not produce the desired benefits. Unless Roth assets represent a meaningful portion of savings relative to tax-deferred accounts, the tax benefits in retirement may be too minor to justify the loss of tax-deferred investment growth.
A CPA or tax advisor can also help by providing projections for the current tax year. Using your income and other assumptions about your available deductions and so on, an accountant can provide information about how the additional income may impact your tax situation for the current year and how much you may be able to convert without getting bumped into a higher tax bracket.
A Roth conversion analysis is always going to be a gamble to a certain extent, as we cannot know what may happen to the tax code in the future. Although the recent changes to the tax code may benefit high-earning taxpayers through more favorable tax brackets, there is another important change all taxpayers should be aware of as a result of the same legislation.
The new tax bill eliminated the ability for investors to recharacterize a Roth conversion for all tax years after 2017. The process of reversing a Roth conversion is called a recharacterization. If your account has declined significantly since converting to a Roth IRA, you would likely benefit from recharacterizing, as otherwise you’d be required to pay taxes on the higher account balance at the time of conversion. Other reasons for recharacterizing may be if you received an unexpected taxable windfall or if you no longer have enough cash on hand to pay the tax due.
[See: 7 Things You Need to Understand About Your 401(k).]
The elimination of this provision makes Roth conversions in 2018 and beyond irrevocable, highlighting the importance of doing a proper analysis and long-term planning. Even though there are multiple aspects to consider, for some individuals, a Roth conversion strategy can really pay off in retirement though increased flexibility and tax savings.
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Why Wealthy Investors Are Reconsidering a Roth Conversion originally appeared on usnews.com
