Tax Arbitrage Strategy – Roth Conversion

A Roth IRA conversion lets you move some or all your retirement savings from a Traditional IRA, Rollover IRA, SEP-IRA, SIMPLE IRA, or 401(k) into a Roth IRA.  There are no age limits to convert, and there are no income restrictions even if your current income disqualifies you from making additional contributions after converting.

The decision to initiate a Roth IRA conversion depends on your family’s financial situation. It should consider enhancing your long-term portfolio value, reducing your lifetime tax obligations, reducing your lifetime Medicare premiums, aligning with your estate planning goals, creating more flexibility in the future.

There are different types of IRAs, with different rules and benefits.  With a Traditional IRA, you contribute pre- or after-tax dollars, your money grows tax-deferred, with withdrawals taxable as current income after age 59½.  With a Roth IRA, you contribute after-tax dollars, your money grows tax-free, and you can generally make tax- and penalty-free withdrawals after age 59½.

You cannot keep qualified IRA funds in your account indefinitely.  Generally, you must start taking withdrawals from your IRA, SIMPLE IRA, SEP IRA, or retirement plan account when you reach age 72.  Roth IRAs do not require withdrawals until after the death of the owner.  Your required minimum distribution (RMD) is the minimum amount you must withdraw and include in your taxable income each year.  The minimum withdrawal calculation is based upon last year’s ending balance on December 31 and your age. A divisor for the RMD comes from IRA tables, one for a married couple and another for single people.

Usually, when clients are in a higher tax bracket, they will contribute to a traditional IRA because they seek a reduction in current taxes. They are assuming they will be in a lower tax bracket when required to take start taking distributions.  Younger people or individuals in a lower tax bracket are not as concerned about current taxes, so they will use a Roth IRA since it provides tax deferral, and later in the future, they will not be taxed when they take money out of the account.  Furthermore, they will never be required to take money out of the account at any time, giving them more control over future tax liabilities. 

Although you will have to pay current income tax on your Roth IRA conversion amount, moving your money can still be advantageous if: 

  • You will be in a higher tax bracket in the future than you are now; converting a traditional IRA to a Roth IRA may be appropriate.  By paying taxes now, you will avoid paying income taxes at a higher tax rate once you retire.  Often there is a time between when a client retires and when they will start taking Social Security and their RMDs.  That time could be a good time for conversion.
  • You are married and similar ages where a survivor RMD distribution would not change, but their single status will compress the surviving spouses’ tax bracket, IRMAA bracket and standard deduction.
  • You are under the age of 63 when your income will impact your future Medicare premiums, and you did the analysis to ensure you are beneath the IRMAA brackets.
  • You have capital losses on some assets, which you can sell to free up cash to pay the income tax resulting from the conversion.
  • If you plan to relocate in retirement to a state with higher income taxes, converting before the move may be appropriate.  For example, we have several clients talking about moving from Florida to Tennessee or North Carolina in retirement.
  • All your financial assets are in qualified accounts, or you have a sizeable, qualified account that will require sizeable withdrawals in the future,
  • You have excess retirement funds and would like to leave a tax-free financial legacy to your heirs.  Beneficiaries who inherit a Roth IRA will be required to withdraw the funds over ten years, but they will not have to pay any federal income tax on their withdrawals if the account’s been open for at least five years.  Since there are no tax consequences, they can take distributions of the entire amount in the tenth year, allowing the funds to grow tax-free for another ten years post-death.  Contrast that with a beneficiary having traditional IRA funds. They will be subject to tax and might benefit from spacing distributions throughout the ten years, so they do not end up in high marginal tax brackets, giving up the benefits of growth.

If you’ve decided to convert your existing retirement account to a Roth IRA., the deadline for the conversion is December 31, 2021, for the 2021 tax year.  The 2017 Tax Cuts and Jobs Act eliminated the ability to recharacterize any conversions or qualified rollover contributions made to a Roth IRA.  You will not be able to change your mind later, so it is best to decide to do the conversion later in the year when you have a better sense of your taxable income. 

When converting a traditional IRA, keep in mind:

  • A distribution from a Roth IRA is tax-free and penalty-free, provided the 5-year aging requirement has been satisfied, and you meet one of the following conditions: age 59½, disability, qualified first-time home purchase, or death.
  • A Roth does not require RMDs during the lifetime of the original owner.
  • If you have to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.
  • If you are under the age of 59½, make sure to convert the entire amount and pay taxes with other funds.  If you do not convert the entire balance you will pay a 10% penalty for the amount you have withheld for taxes.
  • Usually, it makes sense that all ages convert the total amount since these financial assets are non-taxable forever
  • RMD amounts are not eligible to convert to a Roth IRA.
  • Converted assets in the Roth IRA must remain there for at least five years to avoid penalties and taxes.

While we have discussed Roth conversions with most of our clients where they make sense, please let us know if you have questions and think you could benefit from this strategy.

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