What are the factors you must determine when deciding on a Roth conversion
Like many personal finance decisions, there’s typically “gray” areas when choosing between two options. We can forecast many scenarios in any planning engagement, but as we all know, life can throw plenty of curveballs. Because there are enough variables we can forecast, but don’t know for certain, deciding on a Roth IRA conversion typically falls into this gray area of personal finance.
There are many factors that come into play though that can help make these decisions. We’ve been working closely with clients to help them understand the impact and how a Roth conversion can be a beneficial planning strategy for years and generations to come.
Let’s share a bit of the framework that goes into helping clients decide whether a Roth conversion is right for them.
What Made Sense in the Past
Generally speaking, when it came to Roth conversions and the conversations I would have with clients, I would take into account two elements to help make the decision: 1) Age & time frame for use of the funds being converted and 2) Ability to pay the tax on the conversion with cash or assets outside the IRA.
Any conversion is going to “cost” you in the form of a tax upfront, meaning any amount you decide to convert will be taxed at ordinary income rates. The amount of tax you pay all depends on which tax bracket you are in, and being that it’s taxed as ordinary income as opposed to a capital gain, it’s not tax efficient up front. What I always felt was most important in determining if a Roth Conversion strategy was right for a client is the ability to overcome the tax hurdle incurred by the conversion.
The two best ways to overcome this were time to grow the Roth funds & ability to pay the taxes with outside money, thereby keeping the total conversion intact within the Roth. Given recent changes to IRA inheritance rules, the calculus on a Roth conversion has shifted slightly.
I wouldn’t say everything changed at the start of 2020, but there was a major change to the inherited IRA distribution rules that brought other considerations into the roth conversion equation.
A brief overview of the inherited IRA rules. If a spouse inherits an IRA, they can essentially treat it as their own should they choose and would only be required to make distributions as they hit their own RMD rules at age 72. There are some other specifics, but they aren’t required to take immediate distributions if they didn’t otherwise need to.
For non-spousal inheritances, typically children, the distribution rules are much different and they experienced a major change as of January 1, 2020. Prior to 2020, there were a few different options for a non-spousal inheritance (you could take it immediately, could take over 5-years) or you could take it over your own lifetime. The IRS has a table for this, but you were able to take essentially a minimum distribution, and extend the IRA over your lifetime with the benefit of letting it grow long-term.
Beginning in January 2020, the distribution rules changed for a non-spousal inheritance. Instead of taking distributions over your lifetime, you were now required to take distributions within a 10-year window. What does this have to do with Roth Conversions?
Who It may be good for
The basis for a Roth conversion in some cases now has more to do with estate planning than ever before. If you have a client with a large IRA, and maybe they have pension income or other sources of income where they aren’t tapping into their IRA, aside from taking their own RMD, then planning for the next generation can come into play. One major advantage could be getting money out of a traditional IRA and into a Roth IRA. Because the 10-year distribution window could potentially drive up a benefactors tax bracket, having this money come to them in a Roth inheritance can help save A LOT of money in taxes.
As they say - it’s not what you make, it's what you KEEP!
So in the past where the time frame consideration would be weighed, this discussion has changed pretty considerably since the laws changed. Even if a client is retired and getting older, there may be generational considerations to take into account when going through an overall plan and reviewing their estate plan. This is where we can add the most value to our client relationships by fully understanding their financial situation and understanding what longer term goals for their money may be.
Why now could be a good time for a conversion
As a CPA, I believe it's never too early for tax planning. And even though most folks are playing catch up or preparing their 2021 tax returns, it's not too early to start planning for your 2022 taxes.
If you are thinking about making a roth conversion, now may be a good time. Times of market volatility are always beneficial to consider a Roth conversion. Volatility helps in two ways - you may be converting a lesser amount with markets off their highs, so from a tax perspective moving that money out of the Traditional IRA is beneficial as you pay less in taxes. On the flip side, you are moving securities at a discount into the Roth IRA, which now has more room to grow and experience the tax benefits of tax-free distribution. It’s a win-win.
If you are nervous about the markets and think there could be more of a sell-off ahead, you can still convert a portion of what you were considering. Typically, you are only allowed to do an IRA rollover once every 12 months. There is an IRS exception to this rule when it comes to a Rollover from an IRA to a Roth IRA. The one per year rule does not apply so theoretically you could do some now, and maybe another conversion later in the year when you have a better picture of your 2022 taxes. The choice is yours. While we never like to see volatility in the portfolio, it does present some planning opportunities like this.
What should YOU do?
Like most financial decisions, there’s a lot of gray area when determining if a roth conversion is right for you. We have to weigh factors we know vs. the factors we don’t know:
What we don’t know:
Future investment returns
Exact future time horizons
What we know:
Planning for current tax year so we understand tax implications
Helping the client determine what the goals and objectives for this money
As is the case with most planning decisions: control what you can control and plan for the rest. We work hard to take into account the factors we know to be true to make the best decision for the client. That could mean whether or not to do a conversion. If we decide to move forward, how much to keep us within certain tax brackets by doing an in-depth tax analysis. We understand that there are variables outside our control, which we can run scenarios to help us make the best decisions with the information we have.
Many factors are at play, and it's helpful to work with an advisor to make the best decision to align your money with your objectives. If a Roth Conversion is something you’ve considered and want to learn if it's right for you, please reach out and schedule an initial consultation.
Written by: Ryan Bouchey
Check out my firms site: New Age Wealth Advisors