Revisiting the Roth IRA Conversion
/While 2022 has been a down year for the stock and bond markets, there are some actions that long-term investors can take now in order to take advantage of the market dip from an overall financial planning standpoint. For example, although it might not make sense for everybody, some investors may benefit from completing a Roth IRA conversion before the end of the year.
To step back a bit, you might remember that a Roth IRA conversion is a penalty-free taxable transfer of assets from a traditional/Rollover IRA to a Roth IRA. Upon completing the conversion, income taxes will be due on the taxable amount which is converted.
Some of the primary benefits of owning and converting into a Roth IRA include:
1. Regular contributions are allowed at any age into the Roth IRA.
2. Qualified Roth IRA distributions are income tax-free (assuming certain rules are adhered to such as a 5-year holding period and age 59 ½ is reached).
3. There are no Required Minimum Distributions (RMDs) during the Roth IRA owner’s lifetime allowing for additional tax-free deferral and wealth build-up compared to a traditional IRA where RMDs are required beginning at age 72.
4. Without knowing in advance your future income level, as well as the future marginal income tax rates and brackets, shifting some assets to the Roth IRA, a more tax-favored savings vehicle, provides you with different types of accounts to access and greater income flexibility no matter the tax environment.
5. Potential income tax savings can occur if you expect to be in a higher income tax bracket in the future (i.e. during the period when retirement account distributions might be necessary).
6. Roth IRA qualified distributions are not classified as net investment income or Modified Adjusted Gross Income (MAGI), therefore, they are not subject to the 3.8% Net Investment Income Tax on income above a specific threshold (for married couples earning more than $250,000 of Adjusted Gross Income, and for single filers above $200,000).
7. Post-death distributions to beneficiaries are tax-free from a Roth IRA and may be an attractive and flexible asset for wealth transfer purposes if the intention is to pass tax-free IRA assets to family.
8. By paying the income taxes up-front on the Roth conversion, you effectively are prepaying your heirs’ future income tax bills, while simultaneously reducing your taxable estate. This prepayment of income tax is, in effect, an “indirect” gift to your heirs that is not classified as a gift and does not apply toward your lifetime federal gift tax exemption amount ($12.06 million per person in 2022).
In a nutshell, this simple illustration helps with the initial decision on whether moving forward with a Roth Conversion makes sense in your situation.
Clearwater Capital Partners, October 2022
As mentioned above, income taxes will be due on the taxable amount converted in the year of the Roth IRA conversion. By paying the taxes now, it provides the investor with the opportunity to achieve tax-free asset growth and other planning-related benefits simply by holding the funds within the tax-favored Roth IRA in future years.
From a timing standpoint, it makes a lot of sense to consider converting a traditional IRA to a Roth IRA when asset valuations are down and traditional IRA assets have declined in value, which is likely the situation for many investors in 2022. Not only is the amount of income tax due from completing the conversion going to be lower this year, but paying income taxes while the tax rates are historically relatively low can be a prudent planning move.
For a simple illustration of this, consider a married couple in the 24% marginal income tax bracket ($178,150 - $340,100) where one of the spouses owns a $50,000 traditional IRA. The income taxes due on converting the IRA to a Roth IRA in 2022 would be $12,000, assuming that the $50,000 of converted IRA income does not cause the couple to creep into a higher income tax bracket (this calculation also does not factor in possible exemptions and deductions that may apply in the situation).
Assume this same scenario and the $50,000 IRA had declined in value to let’s say, $40,000. The amount of income taxes due from converting to a Roth IRA would decrease to $9,600, resulting in $2,400 of income tax savings from completing the conversion this year.
Although it is very rare to find anybody who enjoys paying taxes earlier than necessary, completing a Roth IRA conversion and paying the taxes upfront has the potential to provide significant tax savings over time, while being a powerful wealth accumulation strategy for investors.
The following graph helps to illustrate this point as it highlights a 60-year old, who completes $50,000 Roth IRA conversions from his traditional IRA for 3 consecutive years (2022-2024). The assets in this example are projected to grow at an annual rate of 6.87%, and we assume that the 60-year old remains in a 22% marginal income tax bracket during the 30-year period shown.
eMoney Advisor, October 2022
As you can see in the bar chart, the small gray section at the top of the bars from years 2022-2036 represents the initial loss to the total pool of portfolio assets from the upfront conversion tax hit.
The combined benefit of the Roth IRA’s tax-free growth and not being required to take annual distributions out of the account at age 72 is realized over time though (compared to tax-deferred growth until 72 and annual RMD withdrawals each subsequent year after 72 if the Roth IRA conversion had not occurred).
After reaching the break-even point in year 2037 (the point at which the initial negative impact on the portfolio asset value from the upfront tax bill is recouped), the steady increase in portfolio value eventually accumulates to a positive advantage of $335,979 at age 90 (as illustrated in the green bars).
Although understanding the upfront tax implications and the long-term impact on the savings bucket through tax-free asset growth is very important, there are several other questions that need to be addressed prior to making the decision to convert to a Roth IRA along with those addressed in the decision tree above. Those would include:
1. Are you in a favorable tax situation this year – is it a lower income year, do you have deductions and/or credits available to help offset or mitigate the income realized from completing the conversion?
If this is the case, then the conversion becomes an easier decision to make.
2. Do you realistically expect to be in a higher income situation in the future and therefore, likely a higher income tax situation?
If you are in a lower income tax bracket this year or simply expect to be in a much higher income situation where you will be subject to higher income tax brackets in retirement, then converting a traditional IRA to a Roth IRA can make sense.
3. What stage in life are you in and what is your health situation - do you expect to have a long enough time horizon to overcome the upfront income tax hit from the potential long-term tax-free growth of the Roth IRA?
In the example above, it took 15 years to make up for the negative impact on the portfolio asset value from the initial income tax bill.
4. Will the Roth IRA conversion adversely affect you in other areas?
One question to ponder is whether a Roth conversion is a wise move when you are close to filing for Medicare and Social Security. A Roth conversion could force you to start paying higher Medicare premiums due to the Medicare Income-Related Monthly Adjustment (IRMMA), which occurs when MAGI exceeds $182,000 for joint filers. There is a two-year look-back on income when determining IRMAA, so performing a Roth Conversion in 2022 can impact your IRMAA status up to 2024 (CNBC.com, May 2022).
Also, the increased income level in the year of the Roth conversion could cause a portion of your Social Security benefit to be taxed and has the potential to push you into a situation where a majority of your benefit is taxed.
5. Should those nearing retirement consider a Roth IRA conversion?
For taxpayers who anticipate a higher tax rate after entering retirement, converting a regular IRA to a Roth IRA after age 60, for example, can help to lower their total tax burden over time by reducing or eliminating the need for required withdrawals (RMDs). As previously mentioned, the possible increase in post-retirement tax costs, such as those related to Medicare and Social Security, need to also be factored in though.
6. How will income tax brackets change in the future?
From a historical perspective, Federal income tax rates are currently at a relatively low level and there are expectations that income tax brackets will increase in the future. The current Federal marginal income tax rates range from 10% to 37% and are set to expire at the end of 2025. If lawmakers don’t extend them, the higher 2017 marginal income tax rates and lower income thresholds where those rates are applied will be reinstated.
7. Are there state income tax ramifications when converting into a Roth IRA?
Roth conversions are treated differently from state to state. For example, Illinois, along with Pennsylvania and Mississippi, are currently the only 3 states that have a personal state income tax but do not tax retirement income and distributions, including Roth IRA conversions.
In summary, although there are many reasons why 2022 is an ideal time for investors to consider a Roth IRA conversion, every situation is unique and it is essential to look at the effect that the conversion can have on one’s overall financial plan.
At Clearwater Capital Partners, financial planning is a core component of the value proposition we provide for our clients. It is an area of diverse subjects, rules, and qualitative considerations which require a high level of competence.
If you are interested in exploring our planning offerings, including Roth IRA conversion strategies, reach out to your Clearwater Capital advisor and schedule a meeting with our Advanced Planning team lead by Kevin Nolte, CPA.
