The Conversion Issue: Tax Me Now or Tax Me Later!

December 18, 2015  |  

The Conversion Issue: Tax Me Now or Tax Me Later!

rothKey Takeaways

  • Converting a traditional 401(k) or IRA to a Roth IRA has become a popular estate planning and tax mitigation technique in recent years.
  • The basic idea of a Roth IRA is to pay some tax now to avoid paying tax on your withdrawals in your golden years.
  • Roth IRAs have many benefits over traditional IRAs, but high earning individuals and couples may not qualify. Also, beware of “tax rate” roulette if you fall into a different bracket later in life.
  • Always keep your beneficiaries in mind when considering a Roth IRA conversion.
  • Roth conversions could be a great option to potentially decrease taxes and pass on tax-free assets to heirs.
  • Roth conversions can also be beneficial if you have assets in tax-deferred accounts and expect a significant drop in your tax bracket before age 70 ½.
  • A re-characterization provides you with a “do over” of a Roth conversion if the assets you converted reduce in value soon after the conversion

Here is a riddle: Would you rather pay taxes now or pay taxes later? 

As the son of a CPA (and a CPA myself), I’ve always believed in the old tax adage, “Accelerate deductions and defer gains.” Therefore my default answer to this question is to pay taxes later.

However, you may question this logic if the tax you expect to pay later is significantly higher than the tax you would pay today. Herein lies the challenge of deciding whether or not to convert your retirement account to a Roth IRA.

It’s no secret that converting pre-tax assets from traditional 401(k)s and IRAs to Roth IRAs has become a popular planning technique ever since 2010. That’s when lawmakers repealed the income limits on Roth IRA conversions. In my experience, this strategy works for many clients, but is not a fit for everyone.

Again, a Roth IRA can be a great planning tool – if it makes sense for you. Please note that the examples below are simplified to illustrate the benefits of Roth conversions. Please consult your tax advisor to determine if this strategy is appropriate for your particular situation.

Who Benefits from Roth Conversions?

When analyzing who may be a good fit for Roth conversions, we typically concentrate on two types of people (though others may fit the profile as well):

1. Those who may be significantly impacted by estate taxes, and
2. Those who may see a significant drop in tax brackets before age 70 ½, and who have assets in tax-deferred accounts (such as IRA’s and 401(k)’s).

There are many moving parts to the first scenario which is outside the scope of this blog (please contact me with questions if you’d like to discuss). So, let’s concentrate on the second scenario—those who have assets in tax-deferred accounts and who expect to move to a lower tax bracket before age 70 1/2.

A common situation in which someone may be a good fit for a Roth conversion is outlined below:

Chris and Erin are a married couple. Both are age 65 and both retired in December 2015. Their annual taxable income while working was routinely $500,000 or more, which put them in the highest tax bracket (39.6%). However, as retirees in 2016, they expect to have taxable income of just $50,000 since they will initially draw from a combination of accumulated cash and taxable investments with very little gain to spend. This temporarily drops them into the 15 percent marginal tax bracket. 

We see this scenario play out quite a bit since most high earners see their tax brackets drop significantly in the first few years of retirement. Some clients I’ve talked to think to themselves, “This is great, I can pay at a low rate and defer taxes a little while longer.” While this is a logical idea, the opportunity cost is enormous given the presence of required minimum distributions (RMD’s) from tax-deferred accounts, which must be taken starting at age 70 ½.  If these RMD’s are expected to be substantial, then those years at a low tax bracket become a missed opportunity.  Let’s continue our example of the newly retired couple to see how this works.

Chris and Erin also have $3 million in traditional IRA assets, so the first full year they turn 70 ½, they’ll be required to withdraw approximately $130,000 to meet their RMD’s, which are taxed at ordinary income rates.

In order to stay ahead of the RMD’s, the couple decides to do a Roth conversion of $100,000 in 2016, which is the remaining amount above $50,000 in the 25 percent tax bracket for those Married Filing Jointly

By performing this transaction, they can save $8,344 in taxes by converting ($29,042 vs. $37,386*, assuming the $50,000 in taxable income + $130,000 in RMD), AND reduce the amount that will be required to come out at 70 ½. 

More importantly, they now have assets in a Roth IRA that can grow tax-free with no RMD’s, and that can be used by Chris and Erin in retirement or can be passed on to their children who can withdraw the funds tax-free!

This transaction could save Chris and Erin thousands of dollars through “tax arbitrage” by enabling them to pay taxes at a lower rate now in order to avoid paying taxes at a higher rate later. It also provides them with a great vehicle to pass their assets on to the next generation. Given such a great strategy, nothing could possibly go wrong, right?

Should You Convert to a Roth?

If you fall under the IRS income limits (see table below), contributing directly to a Roth IRA has many potential benefits.

Phase-outs for Roth IRA eligibility: Modified adjusted gross income

So if you earn too much to qualify for a Roth IRA, what can you do?  Well, if it makes sense, you can contribute indirectly by using a “Backdoor Roth IRA” as we discussed in a previous post. Or you can take pre-tax assets and convert them to a Roth. The strategy gives you the ability to pay tax now on the converted funds for the benefit of never paying tax again on the funds and the related earnings.  This strategy has advantages and disadvantages, which we’ll analyze below:

ia-chart-12-15

Benefits of Converting to a Roth IRA

  • Tax-deferred growth.  Like other retirement accounts, growth within a Roth IRA account is protected from taxes.
  • Tax free withdrawals. As long as you meet the qualifications to withdraw money, all of your contributions and earnings come out tax-free!
  • No required distributions.  Other retirement accounts–including Roth 401(k)s–require you to begin withdrawing money when you turn 70 ½, whether you need the money or not.  There is no such requirement for a Roth IRA, which means your funds can grow tax free for the remainder of your life–and beyond!
  • Great estate planning tools. Much like life insurance, funds in a Roth IRA can be passed to an heir, can avoid probate, and can be used tax-free by the beneficiary. Roth IRA funds can also be “stretched” potentially over the beneficiary’s life which allows for further (tax-free) compounding growth! Needless to say, Roth IRAs can be very powerful tools for passing on wealth to the next generation.

Disadvantages of Converting to a Roth IRA

  • Immediate tax burden.  When you convert to a Roth IRA you face an immediate tax hit.  For example, if you are converting a $10,000 traditional IRA to a Roth IRA and you are in the 33 percent marginal tax bracket, you will owe a tax of $3,300 in the year of the conversion.
  • Tax rates change.  If you convert and the tax rates you pay upon conversion are much higher than when you withdraw the funds, the conversion could have been a bad choice.  No one knows what future tax rates will be, so converting can be a “leap of faith” to a degree.
  • Tax paid from IRA.  If you have to use money from your IRA to pay the taxes on the conversion, those funds will not be able to compound tax-free.  Consider using funds from outside assets to pay the tax to get the most bang for your buck.
  • Tax rate of the beneficiary.  If the beneficiary of the Roth will be in a much lower tax bracket than you, they may receive more money by inheriting the pre-tax assets. Always keep your beneficiaries in mind when performing a Roth IRA conversion.

Is This A “Do Over?”

Not exactly. Something can always go wrong in tax planning. The good news is that you get the opportunity for a free “do over” when a Roth conversion doesn’t go as planned. Let’s take a look at how this works:

Suppose Chris and Erin make their $100,000 conversion in January of 2016 and pay the taxes on that conversion when they filed on April 15th, 2017.  However by June 2017, the investments that they converted for the Roth had decreased significantly in value, and were now worth only $50,000.  They immediately had “converter’s regret” and sought ways to salvage the situation. Fortunately, after speaking with their wealth management team, they discovered that they can actually reverse the Roth conversion by doing a “re-characterization.”

Because their tax liability would have been less if they converted later, they re-characterized the conversion back to a traditional IRA, before the October 15th tax refiling/extension deadline.  They processed the transaction and filed an amended tax return to exclude the $100,000 conversion, recouping the tax paid. 

Once the transaction was complete, they performed the same original conversion again, knowing that if it didn’t go as planned, they could always have a “do over.” 

Conclusion

While this post represents a simplified example of how a Roth conversion may work, I encourage you to contact us to discuss this in more detail if you’d like to learn more.  We’ll continue to look for these opportunities for you if they make sense for your situation. CLICK HERE TO ASK PAT.

*For example purposes, assumes no change in future tax brackets.  Tax figures calculated using 2016 tax brackets.


About Patrick Runyen

As a Wealth Manager at Independence Advisors, Patrick Runyen, CPA/PFS, CFP® works closely with clients to implement wealth management solutions. He leverages his technical financial planning and consulting experience to assist clients with investment counseling, retirement planning, estate planning, wealth enhancement, asset protection, tax planning, and other personally significant financial decisions. CLICK HERE TO ASK PAT.
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