Don’t Overlook Post-Retirement Roth Conversion Benefits

Most advisors understand the importance of talking with clients about the benefits of executing Roth conversions as a part of an effective retirement income planning strategy during the client’s working years. Discussing the pros and cons of the Roth conversion strategy once the client has actually entered retirement is much more rare. However, for the right client, a series of Roth conversions can add significant value, in terms of the improving the client’s income options and tax situation during retirement and furthering estate planning goals. The need to identify tax-savvy financial planning strategies doesn’t disappear once clients stop working and, in the right situation, in-retirement Roth conversions may be a smart move.

Cash and Tax Bracket Control

Retirement can be an ideal time to execute Roth conversions because the client may be in a lower tax bracket when compared with their prime working years.

As an initial matter, it’s important to remember that when traditional IRA funds are converted to Roth funds, the entire amount converted is taxed as ordinary income. If the client doesn’t have sufficient cash on hand to cover the tax liability, the Roth conversion is rarely advisable. Clients with enough cash on hand to cover expenses (in addition to tax liability) during the year of conversion also have the best odds of being in the lowest tax brackets—reducing the overall tax cost of the conversion.

The client’s age is also important. If the client has retired but is not yet required to take required minimum distributions from traditional retirement accounts, they have more control over their income levels for the year of conversion (which, again, can drop them into a lower tax bracket because they aren’t strictly required to make taxable withdrawals from traditional accounts). The same applies to clients who aren’t yet claiming Social Security benefits.

The Roth conversion itself can also serve to reduce the value of taxable RMDs once the client does become subject to those distribution rules.

Building a Roth account can also serve as a hedge against potentially higher future tax brackets. For example, if the client anticipates selling a business or some other asset at some point during retirement, the Roth can be drawn upon to control overall taxable income during that year (i.e., to potentially avoid jumping into a higher tax bracket that year).

Clients should, however, remember that they must wait five years before they can withdraw the amounts that have been converted (regardless of the client’s age)—meaning that the funds converted will be locked into the Roth for at least five years, or the client will incur a 10% penalty on the amounts withdrawn. That five-year clock starts running on January 1 of the year the client executes the Roth conversion.

Estate Planning Workaround

Roth accounts are also a much more valuable estate planning tool in today’s world. Post-SECURE Act, most beneficiaries of traditional retirement accounts must empty the account within ten years of the original owner’s death—and pay the associated tax bill during that period. If the original owner died after his or her required beginning date (the date RMDs began), the beneficiary will also be required to take annual RMDs during years 1-9 after death. Any remaining amounts must be distributed in year 10.

With Roth IRAs, on the other hand, beneficiaries are not required to take required minimum distributions during that ten-year period (the account must still be emptied within ten years of the original owner’s death). Even when the beneficiary does withdraw the funds, they won’t have to pay taxes because they also inherit the benefit of tax-free withdrawals.

Clients who have already accumulated large balances in traditional IRAs before entering retirement may be attracted to this strategy because it essentially allows them to pre-pay their beneficiary’s taxes (hopefully, at a time when the owner is in a much lower tax bracket than beneficiaries who are expected to be in their prime working years when they inherit the account).

Conclusion

As is the case with clients who are in their working years, it’s important to evaluate the client’s big picture to determine whether a Roth conversion strategy might make sense during retirement.

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