Reevaluating Roth Conversion Value Post-SECURE

by Prof. Robert Bloink and Prof. William H. Byrnes

One of the most substantial changes ushered in by the SECURE Act limits the ability of clients to use their IRAs as estate planning vehicles—to “stretch” the tax benefits of the IRA over the lifetime of a younger beneficiary. Under the new law, inherited IRAs generally must be emptied within ten years of the client’s death unless the beneficiary qualifies as an eligible designated beneficiary. For many clients, the convergence of the SECURE Act with 2017 tax reform changes increases the estate planning and tax benefits of the Roth IRA, which can continue to provide tax-free income both during the client’s retirement and to heirs, after death. Before a client jumps on the Roth conversion bandwagon, however, it’s important to take stock in order to avoid several Roth conversion traps for the unwary.

Roth IRAs: Mechanics of the Conversion

When a client converts an IRA to aRoth, he or she pays taxes on the entire value of the amount converted at his or her current ordinary income tax rates. The fact that clients pay income taxes on converted amounts currently is sometimes a deterrent for taxpayers in their prime earning years, who actually generally expect that their tax rates will decrease in the future.

However, clients who planned to leave IRA assets to younger heirs because of the tax benefits might now find themselves reevaluating the Roth conversion strategy—because the Roth account is emptied tax-free. Conversely, if the client leaves a traditional IRA to heirs, the tax liability is now bunched into a ten-year period, rather than spread over a lifetime.

Additionally, tax reform changed the math for many of these clients by both reducing ordinary income tax rates currently and expanding the brackets themselves. For example, in 2020, the 24 percent rate bracket applies for income on a joint return between $171,051 and $326,600—under prior law, the 28 and 33 percent bracket applied to income in those ranges.

Remember that clients can choose which IRA assets to convert, and can convert pieces of the IRA over a period of years to stay in the same income tax bracket over time.

Roth Conversion Traps to Avoid

Clients who are already subject to the IRA minimum distribution rules must be aware that RMDs cannot be converted to a Roth to minimize their tax impact. Under the SECURE Act, the required beginning age was raised to age 72—but clients who had already reached age 70 ½ before 2020 continue to have RMD obligations even if they aren’t yet 72. Clients who are subject to the RMD rules can still execute Roth conversions, but must first take their RMDs from the account.

Clients with nondeductible IRA contributions should also be advised about application of the IRA aggregation rules. Generally, all IRAs are aggregated when determining the portion of the converted amount that is subject to tax and the portion that can be converted tax-free.

For example, if the client has $10,000 in nondeductible contributions in one IRA and $90,000 in tax-free traditional IRA contributions in a second IRA, the entire $100,000 balance has to be taken into account when making a conversion. The client cannot simply convert the $10,000 in nondeductible contributions without tax liability—only 10% of the conversion will be tax-free.

The “five-year rule” is also important when engaging in a Roth conversion strategy. For Roth distributions of account earnings to be taken tax-free, the Roth had to have been open for at least five years and some type of triggering event (i.e., reaching age 59 ½) must have occurred. Further, if the distribution is taken within five years of the Roth conversion, a 10% penalty tax will apply (this five-year period begins to run on the first day of the tax year when the conversion took place). Note that these five-year rules apply only to investment gains in the Roth—the converted amounts themselves are tax-free when withdrawn because the client pays taxes at the time of conversion.

Finally, clients must understand that the old recharacterization rules that allowed the client to “undo” the conversion by October 15 of the year following the conversion were eliminated by the 2017 tax reform package. Because of this, Roth conversions are now permanent once executed.

Conclusion

Roth conversion strategies may now appeal to a much broader group of clients given the substantial changes made by the SECURE Act—and, as always, it’s important that those clients understand the detailed Roth conversion rules before jumping in.