What You Need to Know
- The tax environment is favorable, but what does your client's unique situation look like? Here's what to consider.
- A key consideration is your client’s tax bracket in a given year.
- It’s important to remember that Roth IRA conversions have their own clock for the five-year rule.
Roth IRA conversions are all over the financial news. This is due to several factors that have come together to make Roth IRA conversions more attractive to many investors. These include:
- The sweeping tax overhaul enacted in 2017 lowered tax rates starting with the 2018 tax year. These lower rates are scheduled to end with the 2025 tax year.
- The Setting Every Community Up for Retirement Enhancement (Secure) Act eliminated the ability to stretch an inherited IRA for most non-spousal beneficiaries and requires that these beneficiaries fully withdraw the money in the IRA within 10 years. This applies to inherited Roth IRAs as well, but there is no tax to the beneficiaries in most cases with an inherited Roth IRA.
- There are many unknowns as to what impact President Joe Biden’s tax proposals might have on rates, making Roth IRAs a viable option for many investors.
While the environment is favorable for Roth IRA conversions, the decision and the timing regarding a Roth IRA conversion should primarily be a function of the client’s unique situation as opposed to these external factors. Here are some signs that the time may be right for your client — and one more factor to keep in mind.
1. Your client earned less than usual this year.
A key issue to consider is your client’s tax bracket for the year. If your client is still working and falls into a lower-than-normal tax bracket, that can present an opportunity to do the Roth IRA conversion at a lower tax rate then they would incur during a more normal earning year.
This type of situation might occur for a number of reasons. Perhaps a significant portion of their income is variable, from bonuses or commissions, and this is a down year for them.
Any year that a client who is working finds themselves in a lower-than-normal tax bracket is potentially a good year to consider a Roth IRA conversion. Paying less in taxes on the conversion can enhance its long-term value.
2. Your client has retired but wants to delay Social Security.
One time period where your clients might find themselves in a lower tax bracket is their first few years of retirement. Their income is likely lower due to not receiving a salary or self-employment income. If they’ve decided to delay taking Social Security to maximize their benefit, this could provide a window of several years in which they are in a low tax bracket.
Planning a series of Roth IRA conversions during this period between retirement and drawing Social Security can allow clients to do these conversions while in a low tax bracket. Their income will rise once they claim their Social Security benefits. They will also experience a bump in income if they are subject to required minimum distributions when they reach age 72.
Another benefit for your clients will be reduced RMDs once they reach age 72. The money that is converted, plus any gains on that money, will not be subject to RMDs in the future. This allows the funds that are converted to grow tax-free. It can also help facilitate your client’s estate planning, especially if there are non-spousal beneficiaries on their IRA accounts who will be subject to the 10-year rule under the Secure Act.
It is important to remind your clients who have reached the age where RMDs have commenced that the RMD money cannot be diverted to a Roth IRA conversion and that RMDs must be taken before any conversions are done.
3. Your client wants to donate to charity.
Along the lines of managing your client’s tax bracket, if your client plans to give appreciated assets to charity, the tax deduction from these donations can be used to offset the tax hit of the Roth IRA conversion. It’s important that your client is able to take an itemized deduction for the contribution, however.