As markets recover, converting part of a client's traditional IRA into a Roth IRA can offer significant long-term tax benefits. Any of the recovery would be tax-free. In addition, smaller Roth conversions early in retirement can reduce later RMDs, spreading out the  tax liability more evenly throughout retirement. So, we've gathered everything you need to know about Roth conversions into one place to make it easier for you to help clients take advantage of this strategy. 

Down Markets and Roth Conversions

Many advisors wait until the end of the year to do Roth conversions in order to make sure that the client isn’t accidentally bumped into a higher tax braceket or pay a Medicare premium based on income that arrives late in the year. However, if you have harvested tax losses through this down market, you're are unlikely to have any capital gains on the return at the end of the year. As a result, advisors can do those Roth conversions earlier in the year. That's advantageous for two reasons:

  • Any bounce back comes tax free.
  • It can reduce a future tax burden due to high required minimum distributions (RMDs) from IRAs. 

Recent Legislation

One of the biggest changes created by the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) is that the RMD age was increased to age 72, but only for people born on or after July 1st, 1949. If a client turned 70½ last year, they are still on the old RMD schedule. Those who turn 70 ½ prior to July will get an extra year of deferral and those born in the second half of the year will get an extra two years, creating an additional window for Roth conversions.

Additionally, IRA owners who would otherwise be subject to required minimum distributions can forego making those distributions in 2020 in accordance with the Coronavirus Aid, Relief and Economic Security (CARES) Act. The option to skip the RMD applies to “regular” RMDs, initial RMDs for people who turned 70 ½ in 2019 but decided to forego their initial RMD until tax year 2020, and inherited IRAs. 

The initial RMD would need to have been taken by April 1, while the regular RMD for 2020 would have needed to be taken by Dec. 31. If the initial RMD was taken within the last 60 days, it could be rolled over into an IRA as an indirect rollover, accomplishing the same result as skipping it.  Moreover, if the recipient of an RMD that occurred in 2020 is diagnosed with COVID-19, or was impacted by COVID-19 (guidance will likely be forthcoming) the RMD can be paid back to the IRA any time within the subsequent 3 years. 

For clients who don’t need either their regular RMD or the RMD from an inherited IRA, consider doing a Roth conversion. Roth IRA's don't have Required Minimum Distributions. So, when you do that Roth conversion, that money is allowed to compound over the rest of the client's lifetime, and the majority of the assets that are left behind to the beneficiaries are tax-free Roth IRA assets. For the traditional IRA, you could convert the entire RMD amount, or likely better, only the amount that keeps the client in a key tax bracket. Although you can’t directly convert the inherited IRA RMD to a Roth, by not taking it, the client will have additional room in their current tax bracket, which may make a conversion from their own IRA more desirable.

How Much to Convert?

The 2017 Tax Cuts and Jobs Act significantly lowered marginal income tax rates for most people, and many advisors are now evaluating how much should be converted to a Roth. It’s important to consider not only the tax bracket the client is in today and the starting points of adjacent tax brackets, but also the client’s, or in some cases, their beneficiaries’, tax bracket in the future.

It is most common to consider Roth conversions when a client has significant room to the edge of a tax bracket. For example, a client in the middle of the 12% tax bracket may want to consider converting enough IRA to Roth IRA to fill the 12% bracket, but avoid any withdrawals being taxed at 22%. Because the jump from 12% to 22% is so significant, it’s unlikely a client would want to convert his or her entire IRA.

Quantifying the single-year impact of various conversion strategies enables the client to make an educated decision about the costs of a conversion and avoid potential pitfalls like entering a new bracket, creating Social Security tax, or creating unnecessary Medicare expenses. If the client is within two years of Medicare or already over age 65, then it is worth considering conversions to the point the client would pay additional Medicare part B and D surcharges, which are not calculated as tax directly, but are based on modified adjusted gross income.

It’s also important to take into consideration the lifetime impact of the conversion. For example, the standard deduction for a couple filing jointly in 2020 is $24,800, and there is an extra deduction of $2,600 if both are over age 65. This couple could have about $800,000 of ordinary income over a 30-year retirement without paying any tax at all. If the couple has pensions, the amount from the IRA would be reduced, but it could still be significant. 

How to do Roth Conversions in Income InSight

Income InSight offers a multi-year Tax Map that shows key opportunities to convert and the impact a Roth conversion has on an overall retirement strategy. There are a variety of different conversion patterns to consider. You could harvest to the top of the 12% bracket, to a Medicare premium surcharge threshold, to the top of the 24% bracket, or to the lifetime effective rate. In the last case, you would only convert until your client hit an effective marginal rate that is higher than what they would have paid on average each year had they followed the traditional harvesting pattern. How do you do that?

  1. Identify the optimal Social Security claiming strategy
  2. Generate annual Tax Maps
  3. Identify the average lifetime effective tax rate from the base case
  4. Annually convert until an effective marginal rate is reached that is higher than the effective tax rate from the base case

Income InSight will automatically generate all of this for you. From the report page:

  1. Click on the plan tab on the right-hand side of the page.
  2. Select the "Change Harvesting Pattern" button.
  3. Select the harvesting pattern you'd like to demonstrate and click save.

Compare the harvesting strategy against portfolio longevity, income floor and estate values in the “Base Case” under normal and stressed economic scenarios.

Income InSight is designed for future-focused income planning. As a result, it involves some modeling assumptions and requires expectations to be made regarding the future. The modeling includes sources of income, portfolio (qualified and non-qualified) information, risk assessment questions, tax data and more to develop a base case for income planning. That information can then be stress-tested under various assumptions for the future. The software helps you show clients the lifetime impact value that’s delivered by doing a Roth conversion.

How to do Roth Conversion Strategies in Tax Clarity

Tax Clarity helps you identify how much you can convert to a Roth. The software is designed to consider current year factual tax data from the client's tax returns to find the effective marginal tax rate, or tax on the next dollar of income, paid by the client. It provides a more granular data analysis into the return while allowing for comparative scenarios to be calculated against the base case. Those scenarios can calculate the impact of current year Roth conversions.

Communicating the Benefits of Roth Conversions

Your clients might not realize that each decision made about their retirement plan can impact other areas leading to potentially significant tax inefficiency in their retirement strategy. They are also probably unaware of how beneficial a Roth conversion could be to their overall retirement strategy. It’s important to remind your clients: 

  • Roth conversions can be especially advantageous because the growth comes back tax-free.
  • Doing Roth conversions can spread out the tax liability earlier in retirement.
  • Right now, there are no required minimum distributions under current rules for Roth IRAs, so it’s a good time to consider accelerating off Roth IRA and Roth conversions.

It can be helpful for clients to see the difference a Roth conversion can make. Tax Clarity displays an easy-to-understand Tax Map graphic illustration to help your clients visualize their tax landscape. Income InSight shows the impact a Roth conversion can have on a client’s overall retirement strategy.

Grab your copy of the Financial Advisor's Roth Conversions Handbook here and start making a significant difference when it comes to your clients’ retirement strategies.