Roth IRA conversions becoming more common
My good friend Bob from Munster had a question I thought merited visiting in the column. Bob's question involved a topic we are dealing with more and more often in the practice and a tool we are using more commonly to gain control over taxes -- the Roth IRA conversion.
The question specifically was, "Why, when if ever, should someone cash in their IRA and pay taxes to roll their IRA to a Roth?" So, let's explore some ideas.
Created in 1999, by now most people are aware of the tax features of a Roth IRA. The Roth IRA can receive contributions of earned income while someone is working, or receive conversions from existing IRAs or qualified retirement plans (401(k), 403(b)) during the rollover process.
Contributions to a Roth IRA during one's working years are made on an "after tax" basis, which means the contributions are still included in income and taxed on the front end. The beauty of the Roth IRA, however, is that after funding, the growth in the Roth IRA occurs tax deferred, and when used properly for retirement the funds distributed from the Roth IRA are received tax free.
A Roth IRA can also receive conversion deposits from a Traditional IRA. When a saver converts Traditional IRA funds to a Roth IRA, the conversion amount itself is taxable in the year of the conversion, but then grows tax deferred and distributes tax free for retirement purposes. Also, unlike a Traditional IRA, a Roth IRA does not require Required Minimum Distributions (RMD) at age 73, and it is in this last feature of no RMD that we are finding the planning opportunities.
The age of RMD was phased higher from 70½ in 2020 to 73 in 2025, and is also scheduled to increase again to 75 in 2033. This age change is positive in a number of ways, as it gives taxpayers more control over their income and taxes for a longer time, but there is a downside. As the RMD age has extended, compounded by strong market gains of the past decade, we are finding IRA balances exceeding our planning models and growth targets which is resulting in RMD distributions that are quite large, creating challenges with items like tax brackets and Medicare premium surcharges.
While these are positive challenges to have, as ultimately more money provides more security and opportunity, they are still challenges. The Roth IRA conversion is the tool we are adopting more and more to mitigate these circumstances.
Back to Bob's question. Besides the typically considered tax benefits of the Roth IRA, the "why" of this question now also includes the objective of gaining some level of control over the amount of an eventual future Required Minimum Distribution. Roth IRAs do not involve RMDs, and distributions taken from Roth accounts are not taxable. So, if we can use Roth IRA conversions prior to RMD age to "siphon" off the accumulation inside an IRA, we can essentially slow down the growth of the future RMD and sometimes keep future IRA income from being taxed in a higher bracket. In addition, Roth IRA distributions are one of the only income sources not countable in the government's aggressive MAGI calculation which is used to determine Medicare premium surcharges (IRMAA). Making the answer to the "why" simply: to gain control over future taxation.
The "when" of Bob's question is also important to explore. While we use Roth IRA conversions as a planning tool throughout an investor's entire financial lifecycle, the Roth IRA conversions engineered deliberately to control future RMDs are most likely occurring between the ages of 62 and 71. It is during this period that we are finding investors have more planning control over income, as income during this decade is transitioning from employment over to Social Security and retirement sources such as pensions, IRAs, 401(k)s and investment income. Given that income sources are changing and tax-relevant decisions are being made, the window opens for this planning tool to be considered.
Instead of "cashing in" Traditional IRAs to convert to a Roth, however, we are using a more incremental approach, targeting partial conversions based on tax brackets and other income sources. This incremental approach, as opposed to attempting wholesale conversions, is a very important aspect of the planning conversation, and conversion amounts are highly customized for each investor.
Roth IRA conversions can be a valuable planning tool, and when used deliberately and correctly can provide many long-term solutions. I strongly suggest getting qualified professional tax and financial advice before engaging in Roth conversions, as conversions can also create tax and planning challenges. Thanks Bob, for your question. I hope everyone had a great 4th of July weekend.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Stock investing includes risks, including fluctuating prices and loss of principal. No investment strategy can guarantee a profit or preserve against loss. Past performance is not a guarantee of future results. Marc Ruiz is a wealth advisor and partner with Oak Partners and registered representative of LPL Financial. Contact Marc at marc.ruiz@oakpartners.com. Securities offered through LPL Financial, member FINRA/SIPC.
