Wealth Planning Insights
Opportunities and Considerations for Roth IRA Conversion
Abigail Gunderson, CFP®, October 2023
Roth IRA conversions have become an excellent tax planning strategy in the wealth plans of many of our client families.
What is a Roth IRA Conversion?
A Roth IRA conversion occurs when you move funds from a Traditional IRA or a SEP/SIMPLE IRA into a Roth IRA. Since an account holder is making a distribution of tax deferred dollars during a conversion, the funds converted are taxed as ordinary income in the year of conversion.
However, funds in a Roth IRA continue to grow tax-free throughout the account holder’s lifetime. (A 5-year holding rule applies to each conversion).
What are key opportunities for conversion?
The current marginal tax bracket is lower today than at actual distribution. This could be the case when clients are living on investment income from taxable accounts and expect significant Required Minimum Distributions (RMD) in the future from Traditional/SEP/SIMPLE IRAs.
For married couples, one spouse expects to outlive the other spouse. A surviving spouse transitions to a “Single” taxpayer which is subject to higher tax rates at lower income levels. The converted Roth funds can serve as tax-free income to supplement taxable sources of income and maintain the survivor’s current standard of living.
Huge charitable deductions or carryforwards. A Roth conversion fills up the income that helps absorb a greater percentage of the charitable deduction. (Charitable deductions are subject to Adjusted Gross Income limitations).
Net Operating Loss (NOL) Carryforwards. Ordinary income taxes from a Roth conversion can offset NOL losses in years where businesses may be experiencing setbacks or did not generate any profits.
Roth IRA funds are an excellent vehicle to maximize funds for transferring wealth to the next generation. When non-spouse beneficiaries inherit Roth IRA accounts, the account can continue to grow tax free until the last day of the 10th year following the year of the decedent’s death. (Some exceptions apply.)
High income earners at top brackets can convert now before rates sunset at the end of 2025. Depending on a client’s overall financial situation, it may make sense for high-income earners to consider conversions at 37% today which is still more favorable than the anticipated top tax rate reversion back to 39.6% in 2026. (This provision within the Tax Cuts and Jobs Act of 2017 expires at the end of 2025.)
What are some important considerations when implementing a Roth conversion?
Cash is available for tax payment. Cash is available outside of qualified accounts and not needed for living expenses.
Higher taxable income can result in increased Medicare insurance premiums. For those who are paying Medicare premiums for Part B and D, a Roth conversion will increase taxable income which could affect the Income-Related Monthly Adjustment Amount (IRMAA) that future premiums are based on. Note – the benefits of tax-free compounding on a Roth IRA for an owner’s lifetime can outweigh the additional premium dollars that are spent.
Consider Net Investment Income Tax. Clients need to be aware that a conversion that increases their Modified Adjusted Gross Income (MAGI) levels over $200K (Single) or $250K (Married filing joint) will be subject to the 3.8% “net investment income tax” (Medicare surtax).
Our tax planning tools can help estimate the optimal amount for conversion based on each client’s unique situation. Please contact your Wealth Advisor to help evaluate a Roth conversion strategy that may enhance your wealth plan.