By David T. Mayes
Retirement savers who have built up sizeable balances in tax-deferred retirement accounts like traditional IRAs and 401(k) plans, may at some point want to consider converting some of these balances to Roth IRAs.
Whether paying tax today in exchange for tax-free future withdrawals makes sense largely depends on the expected difference between today’s tax rates and the rates that will apply when funds are eventually withdrawn from retirement accounts for living expenses.
But there are other factors that can weigh on the Roth conversion decision as well including who the ultimate IRA beneficiaries are, whether non-IRA funds are available to pay the tax due on the conversion, how soon funds will be needed from the Roth IRA after conversion, and whether having a high-income year due to the conversion will impact other aspects of one’s financial plan. Here is a logical framework you can use to think these things through.
First, let’s deal with a simple question – will you need to withdraw funds from your retirement accounts during your lifetime? That is likely, but it may be that some retirement funds will be left behind for family members or charities. If IRA funds are destined for charities, Roth conversions make no sense since charities will pay no tax on IRA withdrawals.
A better approach for leaving an IRA to charity is to make Qualified Charitable Distributions during your lifetime (these withdrawals are not included in your taxable income and count toward your Required Minimum Distribution in the year they are completed), then leave the remainder of the IRA to charity.
If an IRA will ultimately go to people, such as a spouse or children who do not have the benefit of a zero percent tax rate, the question is whether the tax rate the beneficiaries are subject to in the future will be higher or lower than the rate you would pay today on the conversion? Part of this is certainly related to their incomes.
If the beneficiaries are minor children or grandchildren, their tax rate is likely to be lower, weighing against conversion. If they are in their peak-earning years, their rates may be higher, tilting the scale toward paying tax today at your known tax rate. In addition, remember that the new RMD rules for non-spouse beneficiaries require that inherited IRAs be fully liquidated within 10 years of the original account owner’s death.
This can trigger large withdrawals that may push the beneficiary into a much higher tax bracket. If the beneficiary is a spouse, keep in mind that a surviving spouse will lose the benefit of filing a joint tax return with its higher standard deduction and tax bracket thresholds leaving a higher tax burden. Converting some IRA funds to Roth ahead of that eventuality may therefore be advantageous.
If the answer to the tax bracket question tilts in favor of a Roth conversion, there are still a few more issues to address before implementing this strategy. First, is there cash available outside the IRA to cover the tax due on the conversion?
This is the best outcome but withdrawing additional funds from the IRA to cover the conversion tax can make sense if future tax rates are expected to remain high and you have a long time-horizon over which the Roth IRA can grow tax-free. Second, you want to be sure you will not need to withdraw any of the converted funds within five tax-years of the conversion as this can trigger a 10% tax penalty. Finally, you must keep in mind certain planning milestones that relate to income.
For example, completing a large conversion just before a child will be applying for college financial aid can significantly reduce aid eligibility which is largely driven by a parent’s income. In this situation, timing of conversions is key. Either complete them more than two years before the first aid application is filed, or after the child’s sophomore year since financial aid applications use tax information from two years prior.
Those approaching Medicare age must also keep the Income Related Monthly Adjustment Amount in mind. Medicare premiums are higher for high-income retirees, with income being based on tax returns from two years prior. A large conversion in 2021, for example, could trigger much larger Medicare premiums in 2023 which will need to be factored into the tax cost of the conversion.
David T. Mayes is a Certified Financial Planner professional and IRS Enrolled Agent at Three Bearings Fiduciary Advisors, Inc., a fiduciary financial planning firm in Hampton. He can be reached at (603) 926-1775 or firstname.lastname@example.org.