3 Things to Consider Before You Do a Roth Conversion

A Roth conversion can be an excellent strategy to reduce your future tax bill, avoid required minimum distributions, or to create a tax-free benefit for a beneficiary. But there are potential pitfalls to be aware of, says adviser Matt Stratman.
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By Matt Stratman

Roth conversions have been growing in popularity over the past few years. The recent tax cuts have allowed many to pay the taxes today at a lower rate and convert into a Roth where their money will grow tax-free. A Roth conversion can be an excellent strategy for many people who want to reduce their future tax bill, avoid required minimum distributions, or use their Roth as a tax-free benefit for a beneficiary. However, there are some potential pitfalls to be aware of, and if you aren't careful, you may end up paying more in taxes and penalties.

Matt Stratman

Matt Stratman

To start with, let's define what a Roth conversion is and why it may be beneficial. A Roth conversion is when someone decides to move money from their traditional IRA into a Roth IRA. The money within the traditional IRA was pretax, and therefore any amount converted is subject to taxes. Someone would do this because they believe they are currently in a lower tax bracket than they will be in the future when the money is withdrawn. Since the Roth allows for tax-free withdrawals, it is a great tool to help reduce your future taxes. Roth IRAs also do not have required minimum distributions in retirement. If left untouched, the Roth could be an easy way to establish a tax-free death benefit for a beneficiary.

The Impact on Medicare and Social Security

If you’re a Medicare beneficiary (or will be one in two years), you should carefully consider the impact of a conversion on your Medicare premiums. Your Medicare part A (hospital) is already "paid in," however, there is a separate premium for part B (medical) and part D (drug coverage). Taxpayers whose modified adjusted gross income (MAGI) is above certain amounts must pay a higher premium for their Part B and Part D coverage. To calculate the increase to your premiums, the Social Security Administration will look at your tax return two years in the past. In 2021 they will be looking at the tax return filed for 2019. Therefore a Roth conversion after 63 will cost the initial tax for doing the conversion and the additional amount paid for Medicare premiums.

Social Security is another area that may be affected. When your total income calculated under the “combined income” formula for Social Security is more than the threshold ($34,000 for singles and $44,000 for couples), up to 85 cents of every Social Security income dollar can be taxed. Social Security defines your combined income as the total of your adjusted gross income plus nontaxable interest, plus one-half of your Social Security benefits. Additionally, 100% of your withdrawals from traditional IRAs and traditional 401(k)s will be considered taxable income. That’s why a Roth conversion could potentially push your combined income above these thresholds and cause your Social Security to be taxed.

While a conversion may negatively impact your Medicare and Social Security if you’re currently or about to receive benefits, the shoe is on the other foot once the money is in the Roth. Any future Roth withdrawals will not increase your Medicare premiums or affect your combined income for Social Security purposes. Therefore, a conversion can be incredibly beneficial for someone not yet claiming Social Security and under the age of 63.

Be Aware of the Five-Year Rule

Withdrawals of both principal and earnings from a Roth conversion are subject to a 5-year waiting period. Even individuals who have already reached the age of 59 ½ still need to wait five tax years before withdrawing from their Roth penalty-free. After the 5-year waiting period has passed, you can withdraw your initial contribution penalty and tax-free. The earnings will be tax-free once you reach 59 ½ and the 5-year waiting period has elapsed.

The IRS starts the waiting period on January 1 of the year you made the conversion no matter when you did it in the year. If you withdraw the earnings too early, they may be subject to a 10% penalty along with any taxes owed. If you feel that there is a likely chance that you may need the money for income in a relatively short period, a Roth conversion may not be the best strategy to help you meet your goals. Ultimately the longer the money is invested in the Roth, the more benefit you will receive from the tax-free growth.

Do It for the Right Reason

The main question is: Will you or your beneficiary be in a higher tax bracket when the money in the Roth is being withdrawn? If you're in a lower tax bracket when the money is being withdrawn a Roth conversion will not benefit you. Many variables determine your tax bracket, including your income, the state you live in, how many deductions and credits you receive, and where tax rates are in the future.

The Tax Cuts and Jobs Act passed in 2017 effectively reduced marginal tax rates, increased the standard deduction, and increased tax credits for many Americans. This act put many people in a lower tax bracket today than before and potentially will be in the future. If Congress doesn't act before December 31, 2025, these regulations will revert to the tax rates in effect before the passage of the act.

Many people who receive a pension or have a high level of investment income may find that their income stays relatively constant even after they retire. However, if your high-income years are in the past, you may find yourself with less taxable income. It's also common for people to relocate from tax-heavy states like New York and California to low-tax states like Nevada or Florida. The combination of relocating and lower-income could cancel out the effects of higher marginal tax rates in the future.

No one knows precisely how high taxes will be ten, twenty, or thirty years in the future. The best way to estimate your tax bracket is to project your future income and run a few scenarios based on different possible tax rates. You should consider all income sources like Social Security, pensions, investment income, and any other source. Based on these projections, you can determine if a Roth is a right solution for your retirement needs.

In conclusion, this strategy can be incredibly beneficial for the right person. The longer your timeline is until you need the money, the more valuable the strategy will be. By implementing this strategy before the age of 63 and before claiming Social Security, you will avoid causing your benefits to become taxable and will not cause an increase in your Medicare premiums. Assuming you're in a higher tax bracket when the money is withdrawn, you will have paid less in taxes when the money went into the account and get the advantage of pulling it out completely tax-free.

About the author: Matt Stratman

Matt Stratman is a financial adviser at Western International Securities. His focus is helping business owners and entrepreneurs who are planning for retirement. With a strong client-centered approach, he creates personalized investment strategies to help them reach their financial goals.