Who Should Convert?
1. Those who will not need the money soon or at all, especially if they plan to pass these funds on to beneficiaries – the Roth conversion is an excellent and effective estate planning vehicle.
Seniors who don’t need the money probably should convert. They are not doing the conversion for themselves; they are doing it for their children, grandchildren and other beneficiaries.
RMDs must be taken before converting
RMDs CANNOT be converted to a Roth IRA. They are not eligible rollover distributions. Only eligible rollover distributions can be converted.
A 78 year old client with a $1 million IRA would be required to withdraw almost $50,000 for the year. If so, he could convert no more than $950,000 that year while he’d owe tax on the amount converted plus on the $50,000 RMD.
2. Anyone naming a discretionary trust as an IRA or plan beneficiary – a Roth conversion removes the trust tax problem.
3. Those who expect their future tax rates to be higher – especially those who are worried about future tax rate increases and might be subject to them (higher income clients).
4. Those who have certain tax characteristics: Can convert at a low tax rate or can convert at no tax cost (if they have offsetting tax losses, deductions or credits.
They can use up low tax brackets, for example the 15% tax bracket should never be wasted.
They can use up NOLs (net operating losses) from a business
They have high deductions, tax credits and other tax benefits that can be used to offset Roth conversion income – but NOT CAPITAL LOSSES! Capital losses can only offset capital gains and up to $3,000 of other income like Roth conversion income.
Look specifically at the tax payment years (will conversions cost less then?)
5. Those who have the money in non-IRA funds to pay the tax (not using the converted funds to pay the tax).
Don’t use the converted funds to pay the tax. This will generally not pay and will be worse for those under age 59½ who will incur a 10% penalty on the amount used to pay the tax in addition to the tax.
In addition, if the conversion is re-characterized (undone), the funds taken from the IRA to pay the taxes cannot go back into the IRA as part of the re-characterization process. They will continue to be treated as a taxable distribution and, if under age 59½, will be subject to the 10% penalty.
6. Young people – younger people generally are in a lower bracket and have not yet accumulated large sums in their IRAs or 401(k)s
Roth IRA Conversions for Younger People are a Must
Suppose 50-year-old Diane has a 28-year-old son, Harris, who has held various part-time jobs while in school and a couple of full-time jobs since graduation. Ideally, Harris has been contributing to a Roth IRA ever since he started to have earned income. If that’s not the case and Harris has a traditional IRA instead, he should convert that account to a Roth IRA immediately.
At this stage of Harris’ life, he probably has a small amount in his traditional IRA and he probably is in a low tax bracket, so a Roth IRA conversion will have a low tax cost. Even a small amount can grow considerably by the time Harris is 59½ and is eligible for tax- free Roth IRA withdrawals. Similarly, Harris has a few thousand dollars in a 401(k) from a former employer. That amount should be converted to a Roth IRA as well.
The same reasoning applies to many clients and their loved ones in the early stages of their careers. A Roth IRA conversion will generate a moderate tax bill now and the payoff might be considerable, in future tax-free income.
7. Those who do not want to worry about paying taxes later, in retirement, when they may need the money
Who Should NOT Convert?
1. Seniors who need the money (no one should go broke converting if they need the funds to live on).
2. Those who believe they will be in a much lower tax bracket in retirement.
3. Those who just cannot bring themselves to pay the tax (especially on large IRAs) or those who don’t trust the government to keep the tax free deal.
The Roth conversion income will increase income for the year of the conversion – potentially causing the loss of valuable exemptions, credits and tax deductions —but this only happens for the year of the conversion.
For those approaching 70½ – RMDs will soon be required anyway, and they will happen every year.
4. Those who do not have available, non-retirement assets to pay the tax due on the conversion.
5. Anyone who asks how soon they can take the money out. If they are going to need the money immediately, why convert to a Roth?
6. Those who have a charity named as an IRA beneficiary. The charity will not have to pay income tax when they inherit the IRA, so why would you want to pay the income tax on a Roth conversion?
On the fence?
Prioritize – what is most important to the client?
Which of the results of a Roth conversion (good or bad) mean most to the client?
And don’t forget that the client can always re-characterize up to October 15th of the year after the conversion.
Hedge – consider partial conversions over several years