Converting traditional retirement funds to a Roth account prior to—or even during—retirement can provide clients with an extremely valuable source of tax-free income later in life—which can help clients avoid or reduce Medicare income-based surcharges and, of course, reduce their actual tax rates.
Despite the many benefits of converting at least a portion of retirement funds to a Roth, clients can easily fall into one of several “traps” associated with Roth conversions—which can actually result in the imposition of penalties in addition to regular tax rates, or even cause the entire conversion to be treated as an improper contribution. Because Roth conversions are now especially attractive in light of the temporarily reduced tax rates imposed under the 2017 tax reform legislation, clients need to be advised of all aspects of the rules governing conversions to avoid adverse surprises down the road.
Expanded Benefits of Converting Post-Tax Reform
Although the 2017 tax reform legislation largely eliminated taxpayers’ ability to recharacterize (or undo) a Roth conversion in situations where poor market performance reduces the benefits of the conversion in hindsight, for many taxpayers, tax reform has created a new incentive to convert. From 2018 through 2025, many taxpayers will benefit from lower tax rates under the temporary individual tax reforms. Post-2025 (or, arguably, post-2020 presidential election), it is possible that tax rates could return to their pre-reform levels or even be raised to higher levels.
Many clients are likely in a lower ordinary income tax bracket in 2019 than they were in 2017, meaning that the up-front tax cost of the conversion will likely be lower at the 2019 rates because the converted funds are taxed as ordinary income to the client.
Potential Missteps in Converting to a Roth IRA
One potential trap in converting to a Roth applies to clients who have yet to reach age 59 ½ (and so are still subject to the 10 percent penalty for early withdrawals). Although the amount converted is not subject to penalty, if the taxpayer withdraws additional funds from the IRA to pay the tax liability generated by the conversion, those funds will be subject to the penalty. Because of this, it’s important that clients be advised to use other funds to cover the tax liability to avoid the added penalty.
The pro rata rule may also impact clients who convert traditional IRA or 401(k) funds to a Roth IRA. The pro rata rule requires that a taxpayer include all IRA assets (valued as of year-end) when determining the taxes due on a Roth conversion. For example, if the client has $20,000 worth of nondeductible IRA assets (perhaps because the taxpayer was executing a backdoor Roth IRA strategy) and converts the entire $20,000 to a Roth, the client will owe no tax on the conversion because no portion of the converted assets represent pre-tax (deductible) contributions.
However, if the client had $80,000 in a 401(k) and rolls these assets into his or her $20,000 IRA, and converts $20,000 to a Roth within the same year, the entire $100,000 IRA balance must be used in determining the portion of the conversion that is taxable—meaning that only 20 percent of the conversion will be nontaxable ($20,000 is 20 percent of the entire $100,000 balance).
If the client had completed the conversion before combining the nondeductible and deductible contributions (or had rolled the deductible contributions back into a 401(k)), the tax liability could have been reduced or eliminated. As a result, by implementing both strategies (the rollover and the conversion) within the same year, a completely nontaxable transaction can be turned into a transaction that is 80 percent taxable—a result that could be avoided if the transactions took place in separate tax years.
Importantly, clients who have already reached age 70 ½ must understand that no portion of their required minimum distribution (RMD) for the year can be converted—and that all IRA withdrawals for the year will be treated as RMDs up until the point where the client has satisfied the RMD requirement.
For example, if the client’s RMD is $40,000 and the client wishes to take the RMD quarterly in $10,000 installments, the client cannot convert until the entire $40,000 has been distributed. If the client converted when only $30,000 worth of RMDs had been distributed, up to $10,000 of the conversion would be treated as an improper rollover (which would require the client to recharacterize, noting that in this type of situations, recharacterization is still permissible).
For clients considering Roth conversions, it’s especially important that they understand all the nuances of the Roth conversion rules—in addition to the benefit of creating a tax-free income source—before choosing to convert to avoid adverse tax results that could erase the benefit of the conversion.