Roth IRAs can be extremely efficient retirement savings vehicles. They are funded on an after-tax basis, and as a long as certain requirements are met, distributions are free of tax and penalty.
Clients can fund their Roth IRA in one of two ways: via annual Roth contributions or by converting assets from a qualified plan or another type of IRA they already own. But whereas annual Roth contributions are subject to modified adjusted gross income (MAGI) limits, Roth conversions are not. It’s one of the reasons any of your clients could decide to convert assets to a Roth IRA.
Just because they can, though, doesn’t mean they should. To help them determine if a Roth conversion is in their best interest, it’s necessary to walk clients through the various tax implications involved, as well as a recent change in the tax law that could give them pause.
First Things First: Tax Brackets and Time Lines
There are two important factors to consider before moving forward with a conversion:
- Your clients’ current tax bracket
- A reasonable estimate of what that tax bracket will be when they retire
For clients who are likely in a lower tax bracket now than they will be in the future, a conversion is ideal. Because distributions of pretax assets from an IRA or qualified plan increase clients’ taxable income in retirement, converting the assets today could result in lower taxes than clients would otherwise incur on their retirement plan distributions down the road. Sure, their current taxable income increases, but the assets in the Roth account now have a number of years to grow, and clients can distribute them tax free in retirement. Generally, Roth conversions are best suited for younger clients with pretax assets in another type of IRA or a qualified plan from a previous employer.
Another important question to ask is, “How much time do these assets have to grow?” You need to know when your clients will start withdrawing from their nest egg—the time horizon you have to work with—because the longer the assets can grow in the Roth account, the more a Roth conversion makes sense. Even if clients think they will be in a lower tax bracket by the time they withdraw the funds, the accumulation of earnings over an extended period and the ability to withdraw that growth tax free may justify paying taxes on a Roth conversion today.
Managing the Mix of Pretax and After-Tax Contributions
The next matter is figuring out how much a client will want to convert—a decision that will depend largely on the tax consequences. If all of your client’s IRA assets consist of pretax contributions and earnings, it is fairly straightforward. All of the assets converted to a Roth IRA will be taxable.
It works differently when someone has a mix of pretax and after-tax IRA assets. Unfortunately, the IRS does not let clients pick and choose which assets they want to convert. Rather, the IRS views all IRAs a client owns as one big bucket of pretax and after-tax funds: the amount of a Roth conversion that will be tax free is determined by the percentage of the client’s total combined IRA balances that represents after-tax contributions. For the purposes of determining this pro rata calculation, the IRS considers pretax and after-tax balances in all of the client’s traditional, rollover, SIMPLE, and SEP IRAs. (Qualified plans, like 401(k)s and inherited IRAs, are not factored into this calculation.)
Example: Bob has two IRAs worth a total of $100,000. IRA #1 is made up of $60,000 in pretax money, and IRA #2 has $40,000 in after-tax money. Bob decides to convert $10,000 from IRA #2 to a Roth IRA. In this scenario, $6,000 will be included in his taxable income, and $4,000 will be converted tax free because 40 percent of his total IRA balance represents his after-tax contributions.
It is imperative that you and your client’s tax advisor be aware of all existing IRA balances, both internally and held away, so you can accurately illustrate how a Roth conversion will affect the client’s taxable income. In addition, the client’s tax advisor will need to file tax form 8606 if a Roth conversion consists of any after-tax contributions.
Thinking Long Term: RMDs and Legacy Planning
Another reason to look closely at Roth conversions is that they can serve as a way to eliminate required minimum distributions (RMDs) once clients reach age 70½—as long as clients pay tax on the IRA assets before retiring. Either on a onetime or periodic annual basis, converting pretax assets prior to reaching RMD age can help clients spread out their tax liability over a number of years rather than experience a spike in their taxable income once their RMDs begin. You may find that later in the calendar year is a better time to determine if a conversion makes sense, as that’s when clients tend to have a more accurate picture of their income for the year. In addition, because RMDs from Roth IRAs are not required while the original account owner is alive, clients could potentially realize more long-term growth in their account well past age 70.
But then what? You may be wondering what happens when clients pass away. First of all, beneficiaries of Roth IRAs are subject to annual RMDs. Will those distributions receive the same tax-free treatment as they would if made by the original owner? The answer is yes. As long as it has been at least five years since the decedent made his or her first contribution, beneficiaries’ RMDs will be tax and penalty free. So, Roth conversions may be viewed as an attractive option for clients who want to leave a tax-free legacy to their heirs.
Client Beware: Recharacterizations No Longer Allowed
Until recently, clients could use a recharacterization to undo a previously processed Roth conversion. This reversal option benefited clients who made a taxable conversion and saw the value of the Roth account decrease but were still responsible for taxes on the initial conversion amount. A recharacterization eliminated the tax liability on the conversion by moving the funds back to the delivering IRA or qualified plan.
The Tax Cuts and Jobs Act did away with this correction method as of January 1, 2018. So, be sure clients understand that if they elect to convert assets to a Roth IRA, they cannot go back on that decision, and they will owe any taxes incurred in the year the conversion is processed.
Focus on the Individual
At the end of the day, clients each have a unique set of circumstances that may or may not make them good candidates to convert assets to a Roth IRA. Be sure to review clients’ current tax bracket and their existing IRA portfolio to determine the tax implications of the Roth conversion now. At the same time, help clients forecast their future income, when they plan to start drawing down their retirement savings, and if they are hoping to leave a tax-free legacy for their beneficiaries.
How do you determine if your clients should convert assets to a Roth IRA? Have your clients used Roth IRAs to leave a tax-free legacy? Please share your thoughts with us below!