Typically, converting IRAs to Roth IRAs is a fourth quarter conversation with clients, as by then they have a pretty good idea of what their financial year will look like as the Dec. 31 deadline nears and how any current (or looming new) tax laws may affect their decision.
But waiting until the final hour to think and talk about a conversion with clients may not leave enough time for adequate evaluation and completion of the task—especially if you have several dozen applicable cases.
So here are some tips to make sure you have ample time to discuss and decide on an IRA-to-Roth IRA conversion.
Why This Year?
The key to timing a Roth conversion is when you believe that the rate at which the conversion will be taxed will be lower now than what it will be when the money is converted or withdrawn in the future.
The tax rate could be lower now for several reasons, including that the clients recently retired and gave up earned income or donated a significant amount of money to a qualified charity or donor-advised fund. And it could be higher in the future due to initiating Social Security or pension payments, receiving a large inheritance, realizing a large capital gain on a sale of an asset or the onset of required minimum distributions (RMDs). The rate could even fluctuate based on general changes in the state or federal income tax rates, or the values of the assets themselves.
Senior clients have even more variables to consider. Older married couples who file their taxes jointly could reasonably decide to convert now while both spouses are alive, since after one spouse dies, the survivor’s standard deduction will be cut in half, while income (like RMDs and Social Security) may not drop nearly as much. Such clients may also choose to convert now if the tax rate today is likely to be lower than what the account beneficiaries might pay when the beneficiaries have to take RMDs from an inherited IRA in the future.
Usually, the best amount to convert is a sum that takes the clients’ total taxable income just up to the top of a particular desired tax bracket, and no more. That optimal number will depend on the clients’ specific financial situation, but for the 2022 tax year the biggest percentage jumps in the federal income tax rate are from 12% to 22% (at $83,550 for married couples filing jointly, half that for singles) and 24% to 32% ($178,150 for married couples, half that for singles).
Watch the Gotchas
The effective tax rate on a conversion is the primary—but not the only—factor and potential cost to consider:
- Extra income from the conversion can trigger income taxes on the clients’ Social Security benefits;
- Clients who are receiving subsidized health care under the Affordable Care Act are required to include the converted amount in the income that determines if they qualify for the subsidy. This calculator can alert them to the potential cost;
- Even those clients who get their health care via Medicare can suffer extra expense because of a Roth conversion, as the amount converted can trigger higher Medicare Part B premiums for at least a year or two after any conversion;
- Clients may also lose certain tax deductions that are phased out at particular taxable income limits; and
- Right now clients with low to no taxable income may qualify for a 0% tax rate on any realized long-term capital gains. However, the converted amount may trigger a tax on those gains that the clients could have otherwise avoided.
What About RMDs to Roths?
Clients who are over the age of 72 and/or have an inherited IRA will be disappointed to find out that their required minimum distribution amounts cannot be converted to Roth IRAs.
Whether an RMD or not, no distribution from an inherited IRA can be converted to a Roth IRA. However, owners of IRAs can convert any amount above their RMD in a given year.
Clients with earned income who are receiving an RMD can hopefully offset that distribution by increasing contributions to a pretax IRA or 401(k), thereby offsetting the income tax on the RMD and adding assets to an account that could eventually be converted to a Roth IRA.
Your firm or custodian can withhold income taxes on the converted amount and pass the taxes on to the appropriate state and federal revenue agencies; but it’s better to convert the entire desired amount to a Roth IRA and then pay any attendant taxes with out-of-pocket money. Just make sure the clients contact their CPA as soon after the conversion as possible to alert the preparer to the converted amount, who can then reply with answers as to if and when estimated taxes need to be paid.
First Fill Out the Paperwork
As soon as you identify clients for whom a Roth IRA conversion makes sense, and get their consent, have them sign and return all the paperwork needed to establish the new vehicle (if necessary) and transfer a yet-to-be-determined amount before the end of the year. Then, once the clients have a more complete picture of their financial year, as well as any changes in the tax law, they can simply give you an optimal figure to use, rather than having to start the whole process at the end of December—which will be here sooner than you (and your clients) think (or want) it to be.
Kevin McKinley is principal/owner of McKinley Money LLC, an independent registered investment advisor. He is also the author of Make Your Kid a Millionaire (Simon & Schuster).