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When to and Not to Do a Roth Conversion

Certain questions come up often in consulting sessions. Topping the list is Roth conversions, where you convert a traditional IRA into a Roth IRA.

Personal factors, your tax bracket, expected future income and when you plan on retiring all play a role. The answer isn’t as simple as playing the tax bracket game (convert below a certain tax bracket only).

Other considerations can affect you taxes down the road. Even Medicare premiums are an issue. A high required minimum distribution (RMD: currently starts at age 72, but pending legislation will gradually raise that to 75, if passed) can cost more than just a tax bill. It can also increase your cost for Medicare.

The best way to handle a Roth conversion discussion is to break it into two parts: the conversion phase and the retirement phase.

 

Taxing the Roth Conversion

Let’s start with income taxes on the conversion. 

If your income is low enough you can convert up to the point where the undesired tax bracket begins. The 0% tax bracket is a no-brainer. If your income falls below the standard deduction or your itemizations, a Roth conversation is a must as you take taxable income and turn it into tax-free income and growth.

Non-refundable credits (for example: Child Tax Credit or education credits) also play a role. More income might be taxed at 0% than what seems obvious. More income can reduce or eliminate unused non-refundable credits. This low-hanging fruit is often overlooked.

For 2022 (unless Congress changes the rules) there is a 10% and 12% tax rate. For many people this is an acceptable tax rate to do a Roth conversion. Personal preference will dictate here. There is a large jump from the 12% tax bracket to 22%. This is a dividing line for many.

 

State Taxes

Don’t forget state taxes. A solid plan can go off the rails if you live in a state with an income tax. For example, in the state where the author lives, Wisconsin, the tax rate goes from 0%  to 5.3% really fast. Wisconsin has a floating standard deduction (the higher your Wisconsin income the lower your standard deduction). You can actually take the standard deduction AND itemize on your State of Wisconsin tax return. 

Arguably, Wisconsin has one of the more difficult tax codes in the U.S. Simple or complex, state taxes still must be considered. Even in low federal tax brackets (10 or 12 percent) you face much higher taxes in some states from a Roth conversion.

A common refrain in my office is that taxes are often times more art than science. This is one of those moments. 

Where you plan to live when retired determines the right choice now. Moving from a high income tax state to a low or no income tax state after retirement is part of the decision tree. If you elect to pay taxes now with a Roth conversion and move from say New York or California to Texas or Florida, you effectively paid state taxes that would not have been due if you waited until you lived in the low-tax state.

 

Early Retirement

When you retire is as important in the decision tree as where you will live when you retire. 

Under current tax law, early distributions from a traditional IRA (except for non-deductible contributions) face tax AND a 10% penalty. (The Roth conversion is an exception to the 10% penalty.) Wisconsin tags you for a third of the federal amount! State taxes need to be watched.

If your only income is from a traditional IRA the penalty might be a low cost solution as long as your tax bracket stays at 0% or maybe 10%. 

Or, you can use §72(t) to take regular and periodic payments without penalty. §72(t) has some strict rules, however. Once started, you need to keep taking a regular and periodic payment until you reach age 59½ or five years, whichever is longer. If you later change your mind you are stuck with taking distributions for the required time or paying the penalty going all the way back to the beginning.

The annual periodic payments are calculated using IRS charts. The distribution may be too small for your needs. Tapping additional retirement funds (that are not Roth) can be problematic. 

My biggest issue with electing §72(t) is the loss of control. Whenever you take maneuverability away from me, the tax professional, I lose some amount of room to lower your taxes in future years. This is why the RMD is such a serious issue. It takes away many tax-lowering options.

 

Tax-free Growth

The main reason to consider the tax issues above is that traditional IRAs are taxed as ordinary income, whereas the Roth grows tax-free. I published on the problem here. 

Tax-free income isn’t the only issue. Some people may decide to withdraw traditional IRA funds and invest the funds in a nonqualified account (a fancy way of saying the money is not in a tax advantaged account like an IRA). The reason is that long-term capital gains and qualified dividends are taxed at a lower rate in most situations. 

All capital gains and dividends in a traditional IRA are distributed as ordinary income, taxed at a higher rate in nearly all cases.

As you can see, the discussion becomes personal fast. Tax brackets are a starting point only. Your personal situation and even future plans are part of the equation. That is why you need to keep this post handy when you retirement plan. Considering all the factors will determine how much money you have after taxes.

And we are still not done.

 

The First Years of Retirement

Before age 59½ you have fewer option. Yet §72(t) and Roth conversions are powerful tools for the early retirees and those planning far ahead.

There are several zones from 59½ to 72. Zones can overlap, too.

Most people can begin collecting Social Security at 62. Full retirement age is a moving target. We will assume 67 is full retirement age to remain consistent in this article. Once you reach age 70 there is no advantage to waiting to start collecting. Finally, RMD’s kick in at 72 (for now).

The first zone starts at 59½ and continues until you start collecting Social Security or you reach 65, whichever comes first.

This first zone doesn’t have to consider consequences for Social Security or Medicare benefits.  Social Security is taxed on the federal return, with an exempt amount based on your modified adjusted gross income. Above the threshold and some Social Security benefits are clawed into income.

 

The second zone has two moving targets: tax brackets and taxable Social Security benefits. More income might claw more Social Security into income, bumping more income into a higher income tax bracket. This second zone only happens to taxpayers who collect Social Security before they are eligible for Medicare.

The first zone, while more involved than just using a Roth conversion at a younger age, is still the best time to maximize you tax situation.

You can still do a Roth conversion in the first zone. You can also take traditional IRS distribution without penalty, allowing you to place the funds in any other investment vehicle of choice.

 

The third zone is for people who have reached 65 and now have Medicare, but have yet to claim Social Security benefits. 

While less of a consideration (because the income limits are higher for Medicare than they are for clawing Social Security benefits into income), Medicare premiums are not fixed. Medicare Part B premiums, for example, are based on your income. 

This third zone does not affect many taxpayers. Still, you need to be aware of the zone in case you are one of the lucky that need to consider these facts and circumstances.

 

The fourth zone is where Social Security and Medicare are both in play, but before age 72 when RMDs kick in.

In this zone you need to combine the income limits from the above zones. As you can see, the tax reducing formula is getting more complex and restrictive. More income can affect the taxability of Social Security benefits and/or Medicare premiums. In simple terms, it is getting harder to reduce the tax liability.

 

Zone five starts when RMDs kick in (age 72 at the time of this writing) until you meet your maker.

In zone five you need to consider taxes on Social Security benefits and premiums for Medicare, while required minimum distributions force your hand. In effect, many times there are no remaining tax reducing strategies once RMDs begin. The RMD can slam you to an income level where Social Security is taxed at the maximum level. Sometimes there are still Medicare premium plays. 

All hope is not lost in zone five. There are still legacy considerations.

Inherited Roth IRAs are still tax-free to beneficiaries. The SECURE Act took away the stretch IRA, where beneficiaries could take distributions from inherited traditional IRAs over their life expectancy. The SECURE Act limits the distribution period for many beneficiaries to 10 years. This is a tax increase!!!

The reason this is a tax increase is because most people inherit retirement funds during their prime earning years. Forcing this additional income when the beneficiary’s tax bracket is already elevated is a tax increase.

Worse, you can’t plan around with complete ease during the 10 years. You are required to take an RMD each year as a minimum, with the entire balance distributed by the end of year 10. Tax planning still has value, but Congress went the distance to minimize how much you can minimize your tax liability.

Note that eligible designated beneficiaries (EDBs) are exempt form the 10-year rule. EDBs include:

  • Surviving spouse
  • Disabled or chronically ill individual
  • An individual that is not more than 10 years younger than the IRA owner
  • Minor children, and
  • Certain trusts

Affordable Care Act (ACA)

As if this wasn’t complex enough (and a good reason you should engage a seasoned tax professional when reviewing these considerations) there are additional considerations.

The Affordable Care Act comes to mind fast. If you are using the ACA (healthcare.gov) your premiums can become very expensive with only a modest addition to income. the ACA can be a huge problem for all taxpayers getting the Premium Tax Credit, especially those in Zone 2 and prior.

 

I have included links throughout this article. They link to the applicable sites that update income limits for each topic discussed. If you undergo this type of tax planning alone you will need those links or another quality information source. 

Small increases in income can cause an outsized tax change. Knowing where the lines are is a serious advantage. Adjusting your income lower (maybe by funding a traditional IRA) can provide massive tax savings. In other cases you can increase your income with only a modest or no change to your tax liability.

The key is to plan. I recommend a seasoned tax professional when building your personal tax plan. However, there is nothing more powerful than coming to the meeting with basic knowledge on how the tax system works when it comes to retirement, retirement income, retirement benefits and the taxes involved. 

 

 

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Tax considerations for Roth conversions at all ages.

Kevin

Thursday 4th of January 2024

We lowered state taxes on conversions by 50% moving from CA to NC - couldn't talk the bride into Florida. With 55% of funds in Roths we are mostly done with conversions. Traditional 401/IRA is source of most funds until 70. What is often overlooked is that after that point RMDs can still be taken tax free if gifted to charities. And the other overlooked point is that one of us is likely to die 10 or so years before the other - and then taxes just about double even if pension income takes a hit. These are big uncertainties, of course, but they are part of the risk mitigation.

Keith Taxguy, EA

Thursday 4th of January 2024

I am a big fan of the Qualified Charitable Distribution (QCD). Every client I have that reaches 70½ and donates to charity gets the speech. They love the benefit.

Mo Mohan

Wednesday 13th of April 2022

Thank you for an excellent article and analysis. Too often we see comments being made about doing Roth conversions without any caveats. Roth conversions have to be analyzed at the individual level. Conversions can be disadvantageous and detrimental. Never hear anything about the downsides. Also, who is prescient enough to forecast tax rates in the future?

Keith Taxguy, EA

Wednesday 13th of April 2022

It is risky business predicting future tax rates, Mo. But when planning a reasonable estimate has to be made. Remember, no decision is a decision. Consequences follow. The good news is that the more factors you consider the more accurate your estimate.

Michael

Tuesday 12th of April 2022

Which trusts are considered EDBs?

Keith Taxguy, EA

Tuesday 12th of April 2022

Taken straight from the IRS website:

Certain trusts created for the exclusive benefit of disabled or chronically ill beneficiaries are included.

Michael

Tuesday 12th of April 2022

Great article. I've tried to put something like this together myself over the years and you did a better job!

Jim Skweres

Tuesday 12th of April 2022

Do you offer a forward looking Tax plan balancing all these factors?

Keith Taxguy, EA

Tuesday 12th of April 2022

When consulting with a client the plan is comprehensive. A single blog post will never cover all facets. It's that "personal situation" thing that makes all the difference. The big part of consulting is getting people to really think about their plans because that is where the tire meets the pavement.