Sizeable Roth Conversion? Consider the Florida Flip

When clients execute Roth conversions, the entire amount converted is taxed as ordinary income. Both federal and state income taxes apply at the time of conversion. Once the amounts have been converted, they'll grow tax-free within the Roth vehicle and can eventually be withdrawn without paying any taxes at all. Even earnings on the investment are nontaxable if the client has owned the Roth for at least five years.

All too often, clients overlook state taxes entirely when converting. Unfortunately, sizeable conversions can create significant state tax liability. For example, New York's state income tax ranges from 4% to 10.9%. California's top income tax rate is 12.3%.

The conversion itself can push a client into a higher tax bracket, so it's always a good idea to run the numbers and plan on executing large Roth conversions over a period of years. All things equal, smaller Roth conversions over the years will generally result in less taxes paid, when compared with a large one-sum conversion in a single year.

Fleeing to Florida: What to Know Before You Go

The move to Florida—or any no-tax state—must be legitimate. High-tax states run residency audit programs. It's very likely that they'll question whether the move was legitimate in an effort to collect state-level taxes they believe they're owed.

When making the move, the client should keep complete and detailed records. Some states, like California and New York, are especially likely to challenge even a seemingly benign move because of the huge numbers of residents that have fled their high taxes (particularly, in the wake of the TCJA's cap on the federal state and local tax deduction).

Taxpayers are also responsible for tracking the number of days they spend within a state. Most states use the 183-day rule for evaluating whether a taxpayer has truly relocated to the no-tax state—meaning that the taxpayer must spend fewer than 184 days in the high-tax state. While this is a helpful test, it's by no means the end of the story.

Clients should carefully review the elements that state taxing authorities will look to in evaluating whether the change in domicile was legitimate. Location of the client's home, and the state where a spouse and children reside and attend school, church and other community events are important, as are other often-overlooked considerations such as vehicle registrations, driver's licensing and voter registration.

Additional Considerations

Clients should also consider ancillary considerations when deciding whether a Roth conversion strategy is worth it. Substantial conversions can impact more than just their tax bill.

Amounts that are converted are registered as ordinary income. Increases in income can trigger Medicare's income-related monthly adjustment amount (IRMAA). IRMAA is an extra surcharge that is added to the taxpayer's Medicare Part B premiums. Medicare uses a two-year lookback period for determining application of the IRMAA.

It's also important to consider paying any tax liability generated by the conversion from a taxable account—and not out of the Roth conversion itself—to maximize the benefit of tax-free growth within the Roth.

Clients must also evaluate the cost of the move itself. Florida, for example, has one of the highest rates when it comes to homeowner's insurance. Steep HOA fees are also common in Florida. These and other costs can eat into the tax savings generated by the move. Some high-tax states offer partial tax exclusions for retirement income that should be considered when running the numbers (New York, for example, excludes up to $20,000 of retirement income from state tax each year).

Conclusion

Relocating to a no-tax state can generate significant savings for clients who are evaluating sizeable Roth conversions later in their working years. That said, it's important to evaluate all of the details before embarking on such a dramatic move. Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.