Should You Utilize a Partial Roth Conversion Strategy?

Imagine for a moment that you have diligently saved for most of your adult life: made the right moves with your 401(k) allocation, taken full advantage of an employer match, and made the sacrifices necessary to enjoy what you hope is a long and fruitful retirement. Then you turn 70½, and you have to begin taking required minimum distributions (RMDs) from your qualified accounts. All of a sudden, you are paying significantly more in taxes than you ever anticipated and could be for the rest of your retirement. But don’t worry just yet! There are ways to mitigate (or even eliminate) this from happening.

Before we get started, let’s first define what a Roth conversion is: the process of taking all, or some, of a Traditional (pre-tax) IRA and transitioning those funds into a Roth (after-tax) IRA. This is done by paying tax on the converted amount in the year that the conversion takes place and will then allow those funds to grow tax-free in the Roth IRA. The major draws of having money in a Roth IRA are 1) any qualified* distributions from the account are non-taxable and thus do not impact your tax return and 2) there are no required minimum distributions (RMDs) for the original account owner.

For many individuals, partial Roth conversions over several years can pay major tax dividends in the future. This strategy works best for taxpayers in lower brackets; ideally, those in the 12, 22, or 24% ranges. The case for this strategy has grown even stronger since the passage of the new tax law, since rates are fairly low from a historical perspective. This gives taxpayers the opportunity to pay taxes now, at a lower rate, and be able to take tax-free distributions in the future when rates are likely to be higher. That being said, this strategy may not make sense for everyone and will depend on current and future market, tax, and economic conditions.

Potential Benefits

Reduce taxable income | As mentioned previously, paying taxes on your Traditional IRA now means eventual distributions* from your Roth IRA will not be taxable and, therefore, will reduce your future tax liability. The benefit to not having to factor these distributions into your adjusted gross income (AGI) are the wide-ranging ramifications that this number has on several other tax elements, including those listed immediately below.  

Lessen Medicare premiums | Medicare premiums start at $134 per month in 2018, but once modified adjusted gross income (MAGI) crosses a certain threshold, premiums will increase. By reducing MAGI through transition of distributions from Traditional to Roth, individuals that are on the cusp of having to pay “income-related monthly adjustments” (IRMAA) may be able to save some money if they can reduce their taxable income and thus drop down to a lower threshold.  

Mitigate (or possibly eliminate) RMDs | As you may already know, or have firsthand experience with, the IRS requires you to start taking a portion of your retirement accounts each year, beginning at age 70½. A higher relative Roth IRA balance translates to lower RMDs, since distributions are not required from Roth IRAs. For individuals who don’t think they’ll need all (or any) of their RMDs, the partial conversion strategy can be especially beneficial. 

Reduce itemized deduction thresholds | While this has become less of a factor due to the new tax legislation (which essentially doubled the standard deduction), reducing your threshold for certain deductions may still prove beneficial for a certain subset of taxpayers. And, there’s always a possibility that the standard deduction amounts will revert back to previous levels and cause more taxpayers to again qualify to itemize.  

Pass on more tax-efficient assets to heir(s) | Any inherited Traditional IRAs will have RMDs due beginning the year after death and which will be considered taxable income to your heirs and taxed at their income tax rate. While RMDs are also due from inherited Roth IRAs, those distributions will be tax-free. In terms of tax-efficiency, it’s hard to find an asset that is better to pass on to heirs. An added benefit: any distributions taken from inherited IRAs are penalty-free due to a qualifying exclusion.

Important Considerations

Do you have enough outside funds to cover taxes? | Ensure you have enough non-qualified funds (i.e. cash, taxable investments) to pay the projected tax liability as you want to avoid using part of the conversion amount to cover those costs; not only will you lose out on future growth on that money, you will also be penalized on those funds if you are under 59½.

Do you have subsidized health insurance? | If the answer is “yes,” you may want to defer leveraging this strategy as the increased income reportable from the conversion could wind up decreasing any premium assistance you might otherwise have been eligible for.  

How soon will you need the funds? | Each Roth conversion has its own “5-year rule” that you need to meet in order for distributions to be considered qualified and tax-free. To meet this rule, a taxpayer must wait 5 tax years prior to taking a distribution (this means that any conversion is deemed to have occurred on January 1st of the tax year that the conversion occurred). Even if the 5-year period is met, a penalty will still be imposed on any withdrawn earnings if the account owner is younger than 59½.

You can no longer re-characterize | With the passage of the new tax legislation, taxpayers will no longer be able to re-characterize their Roth conversions. Previously, taxpayers could “undo” a Roth conversion until October 15th of the year following the conversion. This came in handy for individuals who converted an account (for example, let’s say valued at $100,000) and the market dropped resulting in a $20,000 decline in value. In this instance, the taxpayer would have paid taxes on a $100,000 account that was then only worth $80,000.  

What does this mean for Roth conversions going forward? If your financial advisor anticipates a recession in the near future, it may be wise to wait a year or so before employing this strategy to alleviate the risk that you’ll pay more taxes than you may have otherwise needed to.

Prior to converting your Traditional IRA(s), please consult with your financial advisor and tax professional. Together, they can help you determine the most tax-efficient strategy that will work in concert with your overall financial plan, including your retirement income strategy and legacy goals.

If you ultimately decide to move forward with partial Roth conversions, waiting until closer to year-end (sometime in November/early December) will make the process easier. At that point, you and your accountant should have a better idea of what your total income will be for the year and you can then back into an appropriate Roth conversion amount.

If you’re wondering whether this strategy might work for you, contact us here and we’ll help you formulate an individualized plan. 

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*Please refer to the “How soon will you need the funds?” consideration within this article for more information on qualifying distributions

DISCLAIMER: You should consider all of your available options and the applicable fees and features of each option before moving your retirement assets. Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Like Traditional IRAs, contribution limits apply to Roth IRAs. In addition, with a Roth IRA, your allowable contribution may be reduced or eliminated if your annual income exceeds certain limits. Contributions to a Roth IRA are never tax deductible, but if certain conditions are met, distributions will be completely income tax free.

Opinions expressed are those of Aspen Wealth Strategies and not necessarily those of RJFS or Raymond James. All opinions are as of this date and are subject to change without notice. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

Raymond James does not provide tax or legal services.

Please discuss these matters with the appropriate professional.

About the Author
Stephanie McElheny, CFP®, EA, ChSNC™

Stephanie McElheny, CFP®, EA, ChSNC™

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Stephanie is a Wealth Planner and Vice President at Aspen Wealth Strategies. A Certified Financial Planner™ professional with close to 10 years of industry experience, Stephanie is incredibly passionate about identifying opportunities and implementing comprehensive financial planning solutions for both individuals and businesses. As a Chartered Special Needs Consultant™ and an Enrolled Agent, Stephanie’s specific expertise includes special needs planning as well as individual and business taxation. Stephanie also holds Series 7, 66, and Life, Accident, and Health licenses. Prior to joining Aspen Wealth Strategies, Stephanie has acted as a Director of Financial Planning and a Registered Investment Advisor for both small and large investment management firms. A Pittsburgh native, Stephanie has served as President and Symposium Chair of the Pittsburgh chapter of the Financial Planning Association (FPA), among other roles. She also spent time on the pro-bono committee, offering financial literacy education to seniors, veterans, and underprivileged families. Outside of work, Stephanie enjoys spending time with her husband, Steve, and their corgi, Myron. She is an outdoor enthusiast who loves hiking, camping, cycling, and snowboarding. Stephanie also takes great pride in cheering on her hometown sports teams and alma mater – the Pittsburgh Steelers, Penguins, and Pirates and the Penn State Nittany Lions.

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