An optimal time for a Roth conversion

A strategic approach to a Roth conversion can generate significant tax savings, asset growth, and estate-planning advantages for people who are nearing retirement or are already retired. Jeremiah H. Barlow, Head of Family Wealth Services at Mercer Advisors, outlined the benefits in a May 27 webinar that’s currently available on merceradvisors.com.

“2020 is a unique year for taking advantage of Roth conversions due to some of the changes that occurred as a result of the CARES Act,” which Congress passed in March to provide financial relief from the coronavirus pandemic, Barlow explained. “This is a tax planning strategy that really could provide you with significant tax savings down the road, not only for yourself but also your loved ones.”

Roth IRA rules and basics

Established in 1997 and named after former Delaware Sen. William Roth, Roth IRAs are funded with after-tax dollars while contributions to a traditional IRA generally qualify for a tax deduction. However, Roth IRA balances are not subject to taxation, all future withdrawals are also tax-free, and Roth IRA holders do not have to take a required minimum distribution (RMD) from their account each year. By contrast, withdrawals from a traditional IRA are treated as taxable income, and the account holder must take a yearly RMD starting at age 72.

Because of these key distinctions, a Roth conversion can be advantageous for people with large traditional IRA balances who expect to pay as much or more income tax in retirement as they are paying now. An ideal time to convert funds is in the so-called “notch years”, a year when you might have less income then other years, such as after retirement, but before taking social security and RMDs.

How to do a Roth IRA conversion

Barlow showed an example of how a strategic Roth conversion in a single notch year can allow a person to remain in a lower tax bracket and avoid a larger tax bill while also helping to ensure future RMDs won’t be subject to higher tax rates (see Exhibit A).

Exhibit A: Implementing Systematic Roth Conversions
Remain in lower tax brackets, avoiding higher tax rates today, while helping to ensure your future RMDs won’t be subject to higher tax rates when you retire.

Performance quoted is past performance and is not indicative of future results. For Illustrative Purposes Only. Source: www.kitces.com.

This scenario depicts someone in the 12% income tax bracket, with a base income of $50,300 and roughly $24,800 in deductions, who converts another $60,000 from a traditional IRA to a Roth IRA. The conversion pushes this individual’s total taxable income to just below the threshold of the 22% tax bracket. In this case, the taxes are paid from another source other than the converted amount.

To illustrate the long-term value of this strategy, Barlow described another scenario in which someone with a $1 million traditional IRA balance could dramatically increase their future income by doing 10 years of Roth conversions (see Exhibit B).

Exhibit B: Long-Term Value of Proactive Roth Conversions
Converting annual growth of IRA reduced future required minimum distributions.

Performance quoted is past performance and is not indicative of future results. Assumes IRA balance of $1M at age 60 with 6% growth year-over-year. Roth conversions occur from 62 years old to 72 years old and assumes all IRA growth is converted to the Roth on an annual basis. For Illustrative Purposes Only.

As a result of converting $60,000—equivalent to 6% annual growth in the traditional IRA balance—to a Roth IRA each year from ages 62 to 72, the retiree in this hypothetical example would have a balance of more than $2 million at age 85. This is possible because the person can let their Roth IRA grow tax-free while relying on RMDs from their traditional IRA as income. If left untouched, the Roth IRA balance in this example would reach nearly $5 million by the time the retiree was 100.

“You’re reducing the balance of that traditional IRA, which is helping to reduce the amount you’re going to have to take out in RMDs in later years,” Barlow added. “So, the income tax impact is less on you.”

Benefits of using a Roth IRA conversion

Under the federal SECURE Act, which took effect Jan. 1, 2020, non-spouse beneficiaries who inherit an IRA must (with some limited exceptions) take distributions of all IRA funds within 10 years after the account owner’s death. A Roth conversion helps ensure that the inherited retirement account balance is tax-free—relieving beneficiaries of the income impact from the 10-year withdrawal requirement.

“You can actually use the Roth as one more layer of tax-free benefits,” Barlow said. “Not just for yourself, but it’s now a significant value for that wealth transfer strategy.”

CARES Act impact on Roth conversion rules and strategies

The CARES Act relief package passed by Congress in March 2020 “changed the game when it comes to Roth (conversions) in the sense that two pieces of the puzzle have become more advantageous,” Barlow said. “It waived the 2020 RMDs, which opened the door for Roth conversions.”

People over age 72 who normally would be required to withdraw funds from their traditional IRA can instead contribute to their Roth IRA this year without first having to take an RMD. Also, given the current volatility in the stock market, people have an opportunity to convert IRA assets that might be at a depressed value right now into a Roth IRA for tax-free growth.

For example, a married couple with a base income of $110,000 who normally would take an RMD of $60,000 this year—raising their 2020 taxable income to $170,000—could instead move that $60,000 to a Roth IRA. The couple’s taxable income is still $170,000, but a substantial portion of that money can continue to grow tax-free.

Another tax-saving strategy created by the CARES Act is to do a Roth conversion in tandem with a large charitable contribution. For any cash donations you make to 501(c)(3) public charities this year, you will be able to deduct the full amount—up to 100% of your adjusted gross income (AGI)—on your 2020 tax return. Previously, the deduction limit has been 60% of AGI. Therefore, if you were to make a large charitable donation and do a Roth conversion this year, the tax liability for your Roth IRA contribution could potentially be reduced to zero.

Should you do a Roth conversion

“There are a lot of great opportunities at the end of the day when it comes to Roth conversions,” Barlow concluded. “To navigate this specifically for yourself, you’ll want to determine the cost vs. benefit of paying the taxes now and putting money into that tax-free bucket.” He encouraged people to consult with their financial advisor and tax preparer on the best approach to making a Roth conversion—if doing so would make sound financial sense.