Historically low tax rates over the past few years have made converting a traditional IRA to a Roth IRA extremely appealing for some clients. But for others, low tax rates aren’t enough to make conversions worthwhile.
Roth IRA conversions can be complicated and involve at least two important considerations. Conversions result in an up-front tax expense and are subject to a rule that requires an account owner to wait five years before withdrawing any converted balances, including contributions and earnings, no matter the owner’s age. There can also be a 10% penalty if the money is withdrawn before the five years, which is payable when filing the tax return.
The 10-Year Rule
A widowed client recently inquired about converting a portion of her traditional IRA to a Roth IRA for estate planning purposes. She was interested in transferring a portion of her IRA to a Roth IRA for her son, who would be the sole beneficiary. Her objective was to to avoid the 10-year rule, initiated by the CARES ACT, which requires inherited IRA money to be withdrawn by the end of the 10-year period after the death of the IRA owner. Little did this widow realize, the 10-year rule also applies to Roth IRAs.
I recommended running the analysis of converting a portion of her IRA to see what the impact would be regarding taxes — both current and future. The client told me the combined value of her traditional IRAs was about $1 million and she was interested in converting a quarter of that amount.
Her current estimated taxable income was $80,000 and included a pension and Social Security. She not only pays federal taxes (22%) but is also subject to state taxes (4.25%). She does not intend to withdraw any funds from the Roth IRA for at least five years, unless she has an emergency.
Tax Bumps
Her investment risk profile for the Roth IRA is moderate. Given the mix of her input information, the result of the analysis showed that the future value of her converted assets would be less than if she left the assets in her traditional IRA. That’s because her estimated future federal income tax rate, currently 22%, would bump to 28%.
In addition, her income would be boosted the year of the conversion; this would temporarily push her into a high tax bracket. Her tax rate would jump to 35% and she would owe almost $77,000 in federal taxes and $11,000 in state taxes! The big jump in income could also trigger other one-time taxes such as the 3.8% net investment tax known as the Medicare surtax.
I explained to the client that the funds to pay these taxes would need to come from sources outside of her IRA. Unfortunately, she had not considered the tax and income increase and did not have the financial resources to cover the increase in taxes.
We discussed converting a smaller amount, which would alleviate some of the tax pain. But even the smaller percentage she now intended to convert would still result in a reduction in her investment dollars on the conversion and a substantial hike in her current taxes.
A Better Plan
My recommendation was to do a little at a time; that is enough of a conversion to take her to the top of her tax bracket in order to make the conversion more affordable. She could still achieve her goal of moving a decent proportion of her traditional IRA to a Roth IRA for her son, but she would need to spread the conversion over a longer period of time.
This case is a good example of why it is so important for advisors to do careful analysis before recommending a Roth conversion and to call in a tax specialist if needed.
Becky Gersonde is vice president of Heber Fuger Wendin and currently advises banks, credit unions, foundations and individuals. Established in 1934, Heber Fuger Wendin is an RIA based in Michigan specializing in fixed-income investments for institutions and individuals.