3 Reasons Why You Should Consider a Roth Conversion
Written by: Nicole Gobel, CPA – Wealth Advisor & Tax Planner
At least twice a week, I have a client who asks me whether a Roth conversion is something they should consider in their financial planning. This is also a topic that I often bring up in conversations with clients. Roth conversions have become a hot topic not only because they can be a great tool for tax and estate planning, but also because they are one of many tax strategies that may be changed with the proposed tax changes this year. In many meetings with clients, I ask three questions to help determine if a Roth conversion could make sense for their financial plan.
- Will a Roth conversion reduce overall taxes during retirement?
- Is leaving an income tax-free legacy a priority?
- Are there losses from a business that are not being fully utilized?
Here are three reasons to consider a Roth conversion strategy.
- Roth Conversions as an Income Tax Planning Strategy
- Roth Conversions as an Estate Planning Tool
- Business Losses as a Means to Offset Income from Roth Conversions
Roth Conversions as an Income Tax Planning Strategy
One of the questions to ask when considering a Roth conversion is whether you are currently in a lower tax bracket than you expect to be in the future. If the answer is yes, then it probably makes sense to convert a portion of your traditional retirement account balances to a Roth. This allows you to pay a lower tax bill today than you would upon withdrawal later.
For younger individuals that will benefit from many years of tax-free growth within a Roth, this tends to be an easy decision to make assuming they have access to the cash needed to pay the taxes on the conversion.
However, for those nearing or entering retirement that may not view the funds as having as many years of tax-free growth to offset taxes paid today there are other factors to consider. For example, are you no longer earning income but have not yet elected Social Security or pension income? This could be a perfect opportunity to convert a portion of your account with little to no tax impact. Even if you are receiving Social Security, it is important to know the thresholds for when Social Security becomes 50% or 85% taxable as you may be able to convert a small amount each year.
In addition, you should consider how to maximize any state retirement income exclusions. For example, New York state residents can exclude up to $20,000 each in retirement income each year after reaching age 59 ½. If you’re not taking advantage of this, you’re leaving funds in your account that you can save state taxes on today!
In many cases, clients come to us having saved as much as possible in pre-tax dollars into their employer retirement plans for several years. This means every dollar withdrawn will be taxable and subject to Required Minimum Distributions at age 72. If all distributions are coming from tax-deferred accounts during retirement, they are essentially in the same tax bracket as when they were earning these funds or higher. I have had many clients in my career who have been forced to take distributions and pay income taxes on a much higher amount than they need for cash flow purposes since they did not act earlier. By moving assets to a Roth IRA, which is not subject to RMD, you are effectively reducing your future taxable income and allowing for more flexibility in your retirement cash flow planning.
The key when thinking about Roth conversions as a retirement income tax planning tool is to think about the long-term. No one knows what taxes will look like next year or the year after, however, we can take advantage of what we know now and not be afraid to pay a little tax now for a potentially much larger benefit down the road.
Fun Fact: Anyone can convert their IRA to a Roth IRA.
Roth Conversions as an Estate Planning Tool
I can recall many conversations over the years with estate attorneys asking their opinions on whether they felt Roth conversions should be something everyone should consider. Many of the answers I received were that the income taxes paid today on a Roth conversion could be viewed as a gift to heirs. With the passing of the SECURE Act that became effective in January 2020, this statement is much more poignant.
In the past, when a retirement account such as a traditional IRA was inherited by a non-spouse, the recipient had the option to hold those funds in an inherited IRA and begin to receive Required Minimum Distributions over their lifetime similar to the original account owner. For those who inherited these accounts at a younger age, it allowed them to continue to have tax-deferred growth on the account and minimize the income taxes due, especially if they were in their prime earning years.
As of 2020, due to the SECURE act, any non-spouse who inherits a retirement account is now forced to fully distribute those assets by the end of the year of the 10th anniversary of the decedent’s passing. There is no set schedule, so it allows for some flexibility if someone has lower or higher income years during that window, however, all balances must be distributed by the 10th year. That means accelerating the income taxes paid on inherited amounts, sometimes at a much higher rate. However, although the same 10-year rule now applies to inherited Roth IRAs the huge advantage is there is no income tax consequence upon withdrawal.
Business Losses as a Means to Offset Income from Roth Conversions
One of my favorite stories about great planning is related to a client who had business losses for a few years and had a great CPA who was smart enough at the time to recommend converting large portions of that clients’ IRA balances to a Roth IRA. When I began working with this client and their CPA, they had $5 million in Roth IRA balances. This is certainly not the norm, but the idea of fully utilizing business losses to offset Roth conversions is often overlooked.
As a CPA and Wealth Advisor, I make sure to request a review each year of the client’s tax situation when discussing their investments and financial planning. If a client has business losses it is important to consider what options are available to take advantage of the situation. While capital losses from investments or passive losses cannot be used to offset retirement income, active business losses typically can. Since many business owners may not have a full understanding of their net income until after the calendar year has ended, it’s helpful to have these conversations early and to ask for a reasonable estimate. This would allow you to at least convert a portion of a tax-deferred account to a Roth without much if any tax consequence. We make it a point that even if we are not preparing taxes for our clients that we are coordinating with their tax preparers to ensure everyone is working together for the clients’ best interest.
There are many reasons, three of which are noted above, to consider whether a Roth conversion is the right strategy for you. I encourage you to have conversations with your investment advisor and tax expert now to ensure you are considering all factors as Roth conversions may not be available in the future. If you have any questions regarding Roth conversions, please feel free to contact our team for a discussion.
Bouchey Financial Group has offices in Saratoga Springs and Troy, NY.