A Roth Conversion allows you to move pre-tax assets from an IRA, pay the tax now and re-invest those funds in a post-tax Roth IRA. This strategy can be beneficial if you expect to have a large balance in your retirement account that could be passed on to your non-spousal heirs, who, under the SECURE Act, would have to withdraw these funds over a 10 year period as opposed to their life expectancy.
However, as with any tax-related strategy, there are certain items to be aware of, which we have summarized below. Further, please remember that under the new tax law you cannot undo a Roth Conversion, so it is important to plan ahead.
1. Business Owners Need to Project their Qualified Business Income (QBI) Deduction: The new tax law allows business owners with income under pre-set thresholds ($321,400 for married filers and $160,700 for single filers in 2019) to receive a 20% deduction on their tax return. However, a Roth Conversion can increase taxable income over the QBI limit and eliminate the 20% deduction, so it is important for business owners to run scenarios to see the impact a Roth Conversion has on their overall tax liability.
2. Capital Gains Taxes: It is always a good idea to defer taking gains until you can pay the lower long-term capital gains (LTCG) rates by holding assets for more than one year and one day. Further, if your ordinary income is low enough you may not have to pay any tax on LTCG. However, by completing a Roth Conversion, which is considered ordinary income, you could reduce or eliminate the possibility of paying 0% on LTCG so again, some scenario analysis is needed to determine the impact of a Roth Conversion.
3. Timing of a Roth Conversion: As an extension of item #2, it is important to consider if there are years when you will receive increased income or be able to take increased deductions. For example, completing a Roth Conversion in a year when you expect a large bonus may not be a good idea but if you have large medical expenses to offset a conversion then it may make sense to proceed. Similarly, if you make a Roth Conversion now, you may be able to reduce the Required Minimum Distributions (RMDs) from your pre-tax retirement accounts starting at age 70 1/2, which will allow you to realize larger LTCG in your taxable investment accounts in order to reallocate to less risky assets.
As always, it helps to have open communication between your advisors because tax strategies can quickly become complicated and they require solid input assumptions if the scenario results are to be useful. If you would like to discuss Roth Conversions in more detail, please feel free to contact us.