The Conversion Issue: Tax Me Now or Tax Me Later! (Part 2)

Key Takeaways

  • Roth conversions could be a great option to potentially decrease taxes and pass on tax free assets to heirs.
  • Roth conversions can also be beneficial if you have assets in tax-deferred accounts and expect a significant drop in your tax bracket before age 70 ½.
  • A re-characterization provides you with a “do over” of a Roth conversion if the assets you converted reduce in value soon after the conversion.

In Part 1 of our Roth conversion post, we discussed how a conversion works and some of the potential positives and negatives.  Here we will discuss who may be a good fit for Roth conversions. I’ll also show an example of how this transaction works and explain the free “do over” option if your conversion goes poorly at first. Please note that the examples below are simplified to illustrate the benefits of Roth conversions. Please consult your tax advisor to determine if this strategy is appropriate for your particular situation.

Who benefits from Roth conversions?

When analyzing who may be a good fit for Roth conversions, we typically concentrate on two types of people (though others may fit the profile as well):

1. Those who may be significantly impacted by estate taxes, and
2. Those who may see a significant drop in tax brackets before age 70 ½, and who have assets in tax-deferred accounts (such as IRA’s and 401(k)’s).

There are many moving parts to the first scenario which is outside the scope of this blog (please contact me with questions if you’d like to discuss). So, let’s concentrate on the second scenario—those who have assets in tax deferred accounts and who expect to move to a lower tax bracket before age 70 1/2.

A common situation in which someone may be a good fit for a Roth conversion is outlined below:

Chris and Erin are a married couple. Both are age 65 and both retired in December 2015. Their annual taxable income while working was routinely $500,000 or more, which put them in the highest tax bracket (39.6%). However, as retirees in 2016, they expect to have taxable income of just $50,000 since they will initially draw from a combination of accumulated cash and taxable investments with very little gain to spend. This temporarily drops them into the 15 percent marginal tax bracket. 

We see this scenario play out quite a bit since most high earners see their tax brackets drop significantly in the first few years of retirement. Some clients I’ve talked to think to themselves, “This is great, I can pay at a low rate and defer taxes a little while longer.” While this is a logical idea, the opportunity cost is enormous given the presence of required minimum distributions (RMD’s) from tax-deferred accounts, which must be taken starting at age 70 ½.  If these RMD’s are expected to be substantial, then those years at a low tax bracket become a missed opportunity.  Let’s continue our example of the newly retired couple to see how this works.

Chris and Erin also have $3 million in traditional IRA assets, so the first full year they turn 70 ½, they’ll be required to withdraw approximately $130,000 to meet their RMD’s, which are taxed at ordinary income rates.

In order to stay ahead of the RMD’s, the couple decides to do a Roth conversion of $100,000 in 2016, which is the remaining amount above $50,000 in the 25 percent tax bracket for those Married Filing Jointly.  By performing this transaction, they can save $8,344 in taxes by converting ($29,042 vs. $37,386*, assuming the $50,000 in taxable income + $130,000 in RMD), AND reduce the amount that will be required to come out at 70 ½.  More importantly, they now have assets in a Roth IRA that can grow tax-free with no RMD’s, and that can be used by Chris and Erin in retirement or can be passed on to their children who can withdraw the funds tax-free!

This transaction could save Chris and Erin thousands of dollars through “tax arbitrage” by enabling them to pay taxes at a lower rate now in order to avoid paying taxes at a higher rate later. It also provides them with a great vehicle to pass their assets on to the next generation. Given such a great strategy, nothing could possibly go wrong, right?

A “Do Over”

Not exactly. Something can always go wrong in tax planning. The good news is that you get the opportunity for a free “do over” when a Roth conversion doesn’t go as planned. Let’s take a look at how this works:

Suppose Chris and Erin make their $100,000 conversion in January of 2016 and pay the taxes on that conversion when they filed on April 15th, 2017.  However by June 2017, the investments that they converted for the Roth had decreased significantly in value, and were now worth only $50,000.  They immediately had “converter’s regret” and sought ways to salvage the situation. Fortunately, after speaking with their wealth management team, they discovered that they can actually reverse the Roth conversion by doing a “re-characterization.”

Because their tax liability would have been less if they converted later, they re-characterized the conversion back to a traditional IRA, before the October 15th tax refiling/extension deadline.  They processed the transaction and filed an amended tax return to exclude the $100,000 conversion, recouping the tax paid. 

Once the transaction was complete, they performed the same original conversion again, knowing that if it didn’t go as planned, they could always have a “do over.” 

Conclusion

While this post represents a simplified example of how a Roth conversion may work, I encourage you to contact us to discuss this in more detail if you’d like to learn more.  We’ll continue to look for these opportunities for you if they make sense for your situation. CLICK HERE TO ASK PAT.

*For example purposes, assumes no change in future tax brackets.  Tax figures calculated using 2016 tax brackets.

About Patrick Runyen

As a Wealth Manager at Independence Advisors, Patrick Runyen, CPA/PFS, CFP® works closely with clients to implement wealth management solutions. He leverages his technical financial planning and consulting experience to assist clients with investment counseling, retirement planning, estate planning, wealth enhancement, asset protection, tax planning, and other personally significant financial decisions. CLICK HERE TO ASK PAT.

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