The Roth IRA Conversion: Retirement Planning Tool?
The Roth IRA was designed as a retirement planning vehicle offering unique tax benefits. These accounts are often unfairly categorized as investment tools for younger investors due to the income limits on contributions. The idea being that wages, and therefore taxes, will be lower during the early stages of one’s earning years. Eligibility begins to phase out as earnings increase with limitations beginning at $125k for single filers and $198k for married filing jointly (2021). The IRS did, however, create a back door for those with higher earnings to get money into this powerful tool.
Tax rates of dividends, capital gains, Social Security and Medicare are all sensitive to the amount of income generated each year and can all be negatively affected by RMDs.
Converting Existing Assets from Traditional Retirement Accounts
The Roth IRA differs from a traditional IRA in one important way: the taxation of the funds. Unlike the traditional IRA, money that goes into a Roth has already been taxed. In return for giving up that current benefit, if you follow the rules, the IRS allows any growth that occurs from the investments in the account to avoid taxation altogether! This offers an incredible amount of tax flexibility in both the retirement cash flow and estate plans.
Another powerful feature of the Roth is the lack of a mechanism to force money out of the account. Traditional IRAs and 401(k) plans have a requirement that forces the account owner to begin taking distributions at age 72 (or earlier depending when you were born). These required minimum distributions (RMDs) are calculated using an IRS table and continue until the account value is exhausted. The money that comes out each year is taxed as normal income and can wreak havoc on the efficiency of a cash flow plan. Tax rates of dividends, capital gains, Social Security and Medicare are all sensitive to the amount of income generated each year and can all be negatively affected by RMDs.
Since Roth IRAs do not have this requirement, we have the opportunity to strategically move assets from inefficient accounts into a vehicle that offers incredible flexibility. The mechanics are fairly simple. We begin by evaluating your current tax situation and forecast where you are likely to be down the road. Admittedly, this requires some serious guess work, but we can make some thoughtful assumptions about the direction of taxes in the future. Once we have laid out a baseline for your tax situation, we can make decisions around “filling up” your lower tax brackets. As an example, a married couple with an AGI of $90,000 would have a little more than $82,000 of income left before they reached the next marginal bracket (22% bracket in 2021). This means that we could take $82,000 out of an IRA or 401(k) and move it into a Roth without paying any more relative tax on those funds. This move would make complete sense if your views are that future tax rates will be higher than 22% or if you have a large pension set to begin at some point in the future that will force you into a higher bracket.
Roth conversions can also make estate planning easier. In 2019, the passage of the SECURE Act killed a popular estate planning tool known as the “stretch IRA”. In the past, IRA assets could be passed along for generations, taking advantage of the IRS tables which assign smaller RMD requirements for younger account owners. Under the new rules, however all non-Roth retirement assets inherited by someone other than a spouse must now be distributed within ten years. This presents a huge problem for high earning beneficiaries and could result in a substantial reduction in the total amount of wealth that gets passed along.
The When and the How to Pay for It Matters
Paying the taxes on the conversion requires special consideration. Without diving too far into the weeds here, there are penalties involved with improper use of IRA funds. If you are under 59.5 years old, you should plan on paying the taxes on the conversion with money outside the IRA or 401(k) account. “Grossing up” the conversion will require paying income tax AND a 10% penalty on the money used to pay the taxes. If, however, you are over 59.5 you can use IRA or 401(k) dollars to pay the taxes if you so choose.
Special attention is also required when doing conversions after RMDs have begun. The IRS is very clear in stating that Roth conversions can only be done AFTER the required RMDs for the year have been withdrawn. There is no circumstance where a Roth can satisfy this requirement. It can still be a powerful planning tool for future years but the additional RMD income needs to be taken into account.
The Bottom Line
The Roth IRA is an incredible retirement and estate planning tool. Even if you did not set up an account at an earlier stage of your life, it is not too late to begin harnessing its power. It just requires some careful planning to manage the conversion from a traditional IRA or 401(k), to be sure it works for your situation.
Converting from a traditional IRA to a Roth IRA is a taxable event.