What Do Advisors Need to Know About Roth Conversions?
When the Covid-19 pandemic hit in early 2020, job losses came in record numbers, many businesses were at a standstill, and by March the stock market tumbled. But in all the craziness, one financial move saw its rise to stardom: the Roth conversion.
In fact, Fidelity reported a 76% increase in Roth conversions in early 2020 versus the same quarter in 2019 – and that trend continued with a 67% increase in the last quarter.
With such a sudden increase in popularity, it’s important for advisors and tax planners to not only understand the importance of a Roth conversion, but to be able to explain the advantages and disadvantages in a simple way for your clients.
What is a Roth Conversion?
A Roth conversion occurs when you transfer money from a traditional IRA or 401(k) into a Roth IRA. Sending more of your savings to a Roth IRA account can be a good deal because once you’re in retirement, you get to withdraw that money (both the principle and any growth) completely tax-free.
What’s the catch? Since you initially put your money into a traditional IRA account, you haven’t paid taxes on it yet – all that money you just deposited into your Roth IRA is taxed as income for the year in which the Roth conversion took place.
How Does it Work?
Anyone can do a Roth conversion, but it’s a great touchpoint for advisors to use with clients because it can be an intimidating prospect to address on your own. Since December of 2017, Roth conversions can no longer be recharacterized – which means there’s no undo button, so it’s a great conversation piece with clients.
Some other key details of Roth conversions to be aware of include:
- You don’t have to convert your entire account – you can choose to do just a portion
- There’s no limit to how many Roth conversions you can do
- There’s a five-year waiting period after your first contribution for those under 59 ½ years old – if you touch the money before then, you’ll likely be hit with a 10% penalty tax
When Does a Roth Conversion Make Sense?
Some reasons your clients might want to convert? If a lower income year pushes them into a lower tax bracket, that might be a good time to rollover assets into a Roth IRA. Whether it was a job loss, a demotion, or some other factor, performing a Roth conversion during a low-income year can decrease the tax hit.
Likewise, if a client is pretty sure their salary is only going to go up from here, they’re probably better off to take care of their Roth conversions sooner than later to avoid paying higher taxes in the future.
Any amount you convert will be added to the current year’s income, which has the potential to affect other tax areas. For example, the 3.8% Medicare surtax can kick in with as little as $125,000 in modified adjusted gross income for married couples.
On the other hand, for those looking to bequeath their assets, a Roth conversion can offer a big bonus to heirs. Unlike traditional IRAs, inherited Roth IRAs don’t usually incur any income tax. The rules change when donating assets to a charity or other organization, so make sure to go over the fine print before you make any decisions.
What do your Clients Need to Know?
The ins and outs of a Roth conversion can be hard to explain to clients, but there are some main advantages and disadvantages they should know.
The key benefits of Roth conversions:
- Tax-free withdrawals in retirement (assuming the account is older than 5 years)
- Roth conversions can be used as an estate planning tool to pass on tax-free assets to beneficiaries
- Unlike traditional retirement accounts, Roth IRAs have no Required Minimum Distributions (RMDs) starting at age 72
Some potential disadvantages of Roth conversions:
- No recharacterizations – Roth conversions cannot be undone
- There can be further tax implications than what meets the eye, especially if a Roth conversion is carried out incorrectly – that’s why they want to talk to you!
- Roth conversions have the potential to bump you into a higher tax bracket for the current year
Tax Planning Made Easy
When a Roth conversion is performed correctly, it can be a great tool to offer your clients and prove your value.