Are You Doing Roth Conversions?

Now, is a great time for advisors to consider doing Roth conversions since the CARES Act suspended required minimum distributions for 2020. Plus, any recovery following a significant market dip is going to come back tax-free if those assets were converted into a Roth. Learn more about Roth conversions in our FinPlan Friday conversation with Joe.

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FinPlan Fridays

In our video blog series, FinPlan Fridays, Covisum® Founder and President, Joe Elsasser, CFP®, offers his take on the issues financial advisors see every day. Joe is a practicing financial planner with a unique perspective into the challenges for which Covisum provides technology solutions. Join us on the first Friday of every month for FinPlan Fridays, and get helpful tips to grow your financial planning practice. 


Hi, this is Joe Elsasser, CFP®, President and Founder of Covisum and also a practicing financial advisor, and welcome to another FinPlan Friday. The topic of our talk today is Roth conversions, and Roth conversions in 2020 are a really big deal for a couple of reasons. The first reason is that early in the year, as you may have seen on prior FinPlan Fridays, we had a 30% market dip. Significant market dips are potential opportunities for Roth conversions, because any recovery that might've occurred, in this case did occur, is going to come back tax-free if those assets were converted into a Roth. Now, the second big reason that this is a big year for Roth conversions is because the CARES Act suspended required minimum distributions for 2020. Now, that doesn't mean that you can't take anything out of an IRA. In fact, because the amount of IRA income that will be on many of our client's tax returns in the absence of an RMD is much less than normal, it may be an opportunity to do a Roth conversion for at least some portion of what would have otherwise been withdrawn as a required minimum distribution. So, two big reasons, 2020 is a big year for Roth conversions.


Time Horizon

Now when we start to think about Roth conversions, we really want to think about a variety of things. The first is time horizon, as you know at Covisum, we focus on people in retirement transition and beyond, and all of our tools are built to help them make better decisions and in fact, help you help them make better decisions. And so the first question that has to be addressed is time horizon, because it doesn't make any sense to convert to a Roth if you're just going to turn around and use it in a couple of years. Oftentimes you want multiple years of deferral tax-free growth in the Roth in order to make it really beneficial, but it's not always the case. Sometimes you might have a an incredibly high tax year in a future year, and you might want to use Roth assets instead of IRA assets in that year, but those are specialized cases.


In general, what you're really looking to do is create a long period of deferral. And when you think about the time horizon for a 60 or a 65 or a 70-year-old, that period of deferral is often 30 years or more. And why is that? You have at least 20 years of life expectancy, whether you're 60 or 70. And you've got an additional 10 years that the beneficiary of those accounts is able to leave them in the accounts and get additional tax-free compounding before the beneficiary has to withdraw them. And of course, that's due to the changes in the SECURE Act this year. And so the time horizon for most retirees is at least 20-30 years for Roth assets that you might convert today—assuming they're not going to use them as part of their retirement income. 


However, there are times when they may want to use them as part of their retirement income. And those times really are situations where you have an unusual tax year in which the combination of ordinary income, capital gains and Social Security creates really high, effective marginal rates. You can see those rates for someone in the 12% bracket hit almost 50%. And if you haven't watched any of the Tax Clarity webinars in the past, I definitely suggest you do, because avoiding those even in a few years throughout retirement can make a really significant difference on the longterm performance of a retirement income plan. So, that's the second possibility. Doing conversions so you will have a reserve of assets that you can use that are tax-free. So, they're available to be used in high tax years in order to reduce the overall tax burden or reduce the interaction.


And the third major reason to consider Roth conversions, even for someone in retirement, is because often those assets will be spent last, which means those are the assets that are most likely to be inherited by your client's beneficiary. And if they inherit Roth money, although it is subject to the same 10-year rule as traditional IRA or 401k money, for the beneficiary, it comes out tax-free. Now, oftentimes those beneficiaries may be at their peak working years when they inherit from from our clients or from their deceased parents. And if they're in those peak years, then inheriting Roth money is so much better than inheriting IRA money.


The three big reasons to consider Roths in retirement:

  1. time horizon
  2. potentially avoiding high effective marginal rates (specifically by reducing future required minimum distributions)
  3. the tax-free impact on the beneficiary in potentially their highest earning years when they inherit those funds

So, a host of great reasons to consider Roth conversions, even for your clients who are on the edge of, or even in, retirement. Then the question becomes, "how much to convert?"


How Much Should I Convert to a Roth?

You know, it rarely makes sense to convert all of the client's IRA into Roth in in a given tax year. It almost never makes sense to do that, and yet there are times when it does. Evaluating the client's effective marginal rate, in other words, how much will I actually lose to federal income tax on the next dollar I take from an IRA.  We're being taxed on the Roth conversion in the same way that we would be taxed if we just took an IRA withdrawal. The only difference is the future impact of a Roth conversion is all of that tax-free accumulation going forward.


And so what we really need to do in each year is identify where the soft spots are. And by soft spots, I mean, oftentimes we find ourselves, or we find our clients in a situation where they're in the middle of a tax bracket, maybe they're in the middle of the 12% tax bracket. And our goal should be to get them right up to the edge of the 22% bracket, because of course that's a 10% leap between the 12% and the 22%, or maybe we have clients who, in future years, are highly likely (due to their minimum distributions) to be paying excess Medicare premiums. And so we might consider doing some Roth conversions.


Now, as we're doing those conversions, we're really running the same risks as we are later in retirement. We're running the risk that by doing a conversion, we're going to push somebody into a higher tax bracket, or we're going to trigger excess Medicare premiums. So as a result, we want to be targeting those Roth conversions to identify how much conversion we're able to do without falling into any of those interactions. And if you haven't used Tax Clarity® that's really a fantastic tool for doing so. Do the same same kind of mechanics in any tax planning tool out there, and you'd have to run hundreds of iterations to find those soft spots. So, try Tax Clarity. Use that as a way to identify the soft spots and capture the benefits of Roth conversions for your clients. Particularly in 2020, where we have that additional flexibility with the CARES Act waiver of required minimum distributions for this year. Thanks so much. I hope you learned something, and I look forward to next FinPlan Friday,

How Can Covisum Help You With Roth Conversions?

Our Tax Clarity® software allows you to look at a client's retirement tax landscape to quickly identify sub-optimal tax situations and show clients how to make retirement decisions in the most tax-efficient way. Try Tax Clarity for free for 10 days.