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June 11, 2021 at 04:57 PM
What You Need to Know
- Conditions are currently ripe for Roth conversions.
- Clients should fund the tax liability with non-IRA funds.
- Remember that a client's tax bracket could be much lower during retirement.
While establishing a tax-free source of retirement income is generally a smart play for any client, there are some clients who will benefit more dramatically from a Roth IRA conversion strategy — and timing does matter.
Given the current political climate, the odds are strong that this year will be a prime time for clients to maximize the benefits of Roth conversions. Realistically speaking, we’re almost sure to see some type of income tax increase in 2022 — if not earlier — and with the economy rebounding on hopes of vaccine effectiveness, fortunate clients might even see an increase in income in the coming months.
Conditions are currently ripe for Roth conversions — and clients should be advised on who can benefit the most from the Roth conversion strategy to avoid missing out once this unique window closes.
Reasons to Consider a Roth Conversion Strategy in 2021
As most clients know, Roth IRA funds grow tax-free and are withdrawn tax-free during retirement. However, only clients with income below certain threshold amounts can contribute after-tax funds directly to a Roth. Higher income clients can fund a Roth by converting traditional IRA funds (usually contributed pre-tax) and paying tax on the converted amounts in the year of conversion.
Currently, income tax rates are at historic lows under the 2017 tax reform legislation. Nearly all of Biden’s pending proposals involve increasing the top income tax bracket to pre-reform levels — meaning that clients will pay more taxes on conversion if (and when) those proposals become law.
Despite this, clients should carefully evaluate their personal financial situations before executing a conversion. It’s important to examine both the current financial landscape and potential future changes in the client’s circumstances that could impact the value of a conversion today.
Practical Considerations When Considering a Roth Conversion
A tax-free source of income should be part of any well-diversified portfolio. It’s impossible for anyone to predict the future with 100% accuracy. Tax rates might increase — or the client might find themselves in need of extra funds during retirement. A Roth IRA offers a tax-free source of income to allow clients to control their taxable income later in life to avoid jumping into a higher tax bracket because of an unexpected financial need during retirement.
Clients who anticipate higher tax rates or expect to be in a higher tax bracket in the future can minimize their tax liability by converting now. That way, they can pay taxes at the current lower rates — freeing up more funds for additional retirement savings.
On a related note, it’s always best to fund the tax liability with non-IRA funds. Clients who must rely on IRA funds to pay the taxes on a Roth conversion are essentially paying taxes on the converted funds that they’re using to pay taxes.
