Common Roth IRA Conversion Opportunities
Written By: Brian Ellenbecker, CFP®, EA, CIMA®, AEP®, CPWA®, CLTC®
As Shakespeare Financial Advisors, we are often asked whether or not a Roth IRA conversion makes sense. Most of the time, the answer ends up being more complex than they thought. There are many factors to consider in this decision.
Before looking at particular scenarios, it’s important to understand that the main driver of Roth IRA conversions is tax rates. Compare your current tax rate to your projected future tax rate when you would otherwise take a distribution from your IRA. If you’re able to shift money today at a tax rate that is lower than what you expect to pay in the future, then a Roth conversion might make sense. In that situation, while you are voluntarily paying tax sooner than required, you’re able to do so at a lower expected rate. Then, those assets can grow tax-free in the Roth IRA going forward, which is the benefit of a conversion.
Let’s look at some of the more common situations where a Roth conversion might make sense. Please keep in mind that every situation does not apply to everybody. What works for one person may not work for someone else due to differing circumstances.
Retirement Until Required Minimum Distribution Age
Once you retire, your employment income ends, and your taxable income now starts at $0. Most likely, you have at least a few years until you reach the age you start taking mandatory distributions from your retirement accounts (age 73 or 75, depending on the year you were born). You might not even file for Social Security right away, giving you an even bigger opportunity for a Roth Conversion.
Many people in this window might be able to convert money to a Roth IRA at lower brackets than they had access to while working, which could also be lower than their expected tax bracket once required minimum distributions stop. If that proves to be the case, a Roth conversion could provide a meaningful tax benefit over time.
Planning Tip: If you are age 63 or older, you also need to worry about IRMAA (Income-Related Monthly Adjustment Amount), which is the extra Medicare premium you must pay once your income reaches a certain amount. Make sure the additional income from a Roth conversion does not push you into a higher IRMAA tier unexpectedly.
You Anticipate Your Income to be Lower than Usual or Deductions to be Larger than Usual
If you have a year when you expect your income to be lower than usual or you have larger than normal deductions, you might want to consider a Roth conversion.
Income can decline for a variety of reasons (retirement, changing jobs, starting a business, job loss, divorce, etc.). If your income drops and it creates an opportunity to move money to a Roth IRA at a lower than expected tax cost, that could be a great tax planning opportunity.
The most common reasons why your deductions may be larger than in a typical year are that you plan to make a larger charitable contribution, or you have a business loss. Either of those could create a large deduction which, in turn, lowers the tax cost of a Roth IRA conversion.
You Expect to Leave an Inheritance and Your Beneficiaries are in Higher Tax Bracket
If you plan to leave a legacy to your heirs and part of what you’re leaving behind includes retirement accounts, consider your tax rate relative to your beneficiaries’ tax rates. When factoring in the tax cost to the family over different generations, it could make sense for you to convert to a Roth IRA at your current tax bracket (and perhaps even higher ones) if you plan to leave retirement assets to your heirs. If you find yourself in a lower tax bracket than your heirs will be in when they need to withdraw assets, converting during your lifetime and essentially pre-paying the tax on their behalf could result in tax savings over multiple generations, even if the impact isn’t an immediate benefit to you.
This technique could be especially effective for non-spouse beneficiaries who will have high income when they expect to inherit those assets. Because their inherited retirement accounts will need to be depleted according to the 10-year rule (with the possibility of annual distributions also being required), inheriting a Roth IRA vs. a Traditional IRA could lead to meaningful tax savings, especially if it’s a larger IRA.
Planning Tip: The above strategy only applies if the beneficiaries of your retirement accounts are people. If they are charities, you would not want to do a Roth conversion, as charities are tax-free entities and do not pay tax on retirement account distributions.
Determining if a Roth IRA Conversion makes sense is only the first step. The next step is to calculate the appropriate amount to convert. Most likely, converting a portion of your IRA, rather than the entire amount, will lead to the best tax result. While a Roth Conversion may seem simple on the surface, the planning around it is usually complicated. Talk with your Shakespeare advisor and tax advisor to help you work through that calculation.