Roth conversions are a great way for financial advisors to help their clients manage tax obligations in the short term while also reducing overall taxes paid during retirement. As a financial advisor, your job is to recognize when a Roth conversion can benefit your client’s wealth management strategy and to identify the specific conversion strategy that will help your client achieve their financial goals.
The decision to conduct a Roth conversion isn’t always automatic. Unique client considerations can affect the ideal timing of conversions. In addition, your clients may need your guidance to fully understand how a Roth conversion will impact their retirement income through taxes and their Social Security benefits.
Poorly executed Roth conversions can end up creating large tax bills your clients aren’t prepared for. They could end up costing more in the long run if your clients’ current tax rate is higher than what they are likely to pay in retirement.
Each Roth conversion strategy should be developed specifically for each of your clients. Here’s a road map for approaching this process.
Common Types of Roth Conversion Strategies
Most Roth conversion strategies follow one of the following four blueprints.
1. Backdoor Roth IRA
Income limits may prevent some of your clients from making contributions to a Roth IRA. But there’s still a way to take advantage of this tax-free retirement fund through a strategy known as a “backdoor Roth IRA.”
With this strategy, high-income clients can make contributions to a traditional, tax-deferred IRA and plan to convert those funds into a Roth IRA later. This strategy only became available in 2010, when Roth IRA rules were changed to get rid of income limits on Roth conversions.
Executing a backdoor Roth IRA can be complicated if your client has multiple IRAs under their name because this creates a complicated tax scenario that might nullify some of the tax advantages of converting to a Roth. In this case, you might need to first roll your client’s IRAs into a 401(k) and use this retirement fund as a way station that then allows you to avoid the tax rules enforced when converting traditional IRAs to a Roth IRA.
2. Mega Backdoor Roth IRA
This strategy only applies to clients who have a 401(k) plan through their employer. Your client first makes contributions to an after-tax 401(k) fund, and those funds are later converted to a Roth IRA within that 401(k) plan. By first funding the after-tax account, your clients can generate a much larger investment amount for their Roth IRA than they could invest by making direct contributions to that fund.
3. Conversion-Cost Averaging
When the stock market declines, the monetary value of those holdings is lower across the board—which can essentially give your clients a discount when timing their Roth conversion. If the market declines by 20 percent, for example, the conversion-cost averaging strategy essentially allows them to convert the same assets into a Roth account while paying taxes on roughly 20 percent fewer assets. Tax brackets are static, but retirement fund values are subject to change. Conversion-cost averaging allows you to leverage these discrepancies, as long as you time your trades wisely.
4. Conversion Barbelling
Those static tax brackets can also be used to measure out your conversion amounts over time in a manner that minimizes your clients’ tax obligations. This is done by adding up conversion amounts to maximize your clients’ reported income in their current tax bracket, up until the point at which their tax bracket would increase.
Because this strategy requires a precise calculation of taxable income, it is most often executed at the end of the tax year.
Key Steps to Developing a Strategy
Once you understand the leading strategies used to guide Roth conversions, you need to evaluate each of your clients’ financial outlooks to determine which approach provides both the best immediate value in terms of tax savings and the most long-term value by preserving investment funds and allowing them to grow tax-free in the years to come.
Here are the key steps to follow as you create a custom strategy:
1. Identify the best Social Security claiming strategy.
Roth conversion strategies need to account for Social Security when it comes to retirement income planning. These retirement funds combine with Social Security to provide your clients with consistent income after they stop working, but there is a lot of flexibility in how these can be combined, especially when it comes to tax considerations.
Clients with a strong retirement fund, for example, may prefer to lean on withdrawals from those accounts while delaying Social Security benefits and increasing their total benefit amount. Alternatively, clients may prefer to structure withdrawals and Social Security benefits to minimize their overall tax burden.
2. Generate a Tax Map for your clients.
To complete this step, advisors must calculate the implications of several different scenarios their clients may be considering, including not only withdrawal schedules and Social Security timing but also their desired retirement age. This strategy offers space for creative thinking: Advisors may recommend, for example, using the conversion barbelling strategy to convert more funds to a Roth and taking Social Security benefits—while staying below the threshold beyond which Social Security income is taxed.
Ultimately, advisors will want to identify the strategy that achieves the lowest effective marginal tax rate possible while still supporting a wealth management strategy that achieves their clients’ goals. A Tax Map is instrumental in illustrating the complicated tax burden that can come with seemingly minor changes to an IRA withdrawal strategy.
3. Establish a base case using realistic scenario planning.
Retirement wealth management always requires an assumption of certain variables that are subject to change. Retirement ages can be adjusted; lost income or a sudden windfall can force an entirely new financial planning strategy.
Like any other financial decision, Roth conversions should be based on realistic income and tax scenarios for the future. Likely tax rates and future income earnings may deviate from these calculations, but the base case offers a reliable measure to identify an average lifetime effective tax rate. From there, advisors can help clients choose the right Roth conversion strategy—and a timeline for making these conversions—to limit their tax obligations and preserve more of their earnings.
4. Identify your clients’ annual conversion threshold.
The annual conversion threshold is, essentially, the maximum amount your clients can convert in a tax year before the marginal tax rate exceeds the rate of the regular tax bracket. This threshold will help you calculate the amount you’re able to convert into a Roth IRA each year without pushing your clients’ income into a new tax bracket. Although this threshold may change over time as tax rates change, it can help determine conversion amounts over a multi-year Roth conversion strategy.
A Flexible Approach to Roth Conversions
Roth conversions always require certain assumptions about future financial implications, including annual earnings and the tax rate for certain income brackets. Consider adding Tax Clarity to work through the best strategy for your clients this year. Then, you’ll have the opportunity to use Income InSight to work through the long-term and make projections based on the information known today.
These tools help you show the impact of immediate goals, as well as the lifetime impact. Each year, you will need to revisit these conversion strategies and adjust conversion amounts as needed by re-running the Tax Map and the Income InSight five-year projections to optimize this wealth management strategy and maximize the tax benefits of these tools.