Is a Roth IRA conversion key to strategic tax planning?

As financial advisors, our heroics don’t typically make for riveting dinner conversation, but in our daily duties, we frequently step in and save the day. We wield advanced modeling tools to optimize our clients’ retirement portfolios. We brandish calculators and sophisticated software to free clients from nagging tax liabilities and penalties.

One tool that seems to surface more and more in our daily quest to help clients is the Roth IRA conversion.

Why consider a Roth IRA conversion?

Many of our clients benefit from the tax-free growth and withdrawals they receive during retirement with a Roth IRA conversion. Unlike traditional IRAs, our clients’ contributions to a Roth IRA are made with after-tax dollars. Clients will not receive a tax deduction for the year they make their contribution, but their qualified withdrawals during retirement are completely tax-free. This can result in quite a bit of tax savings, especially if their investments grow substantially.

Many clients also appreciate that Roth IRAs do not force them into required minimum distributions. The IRS mandates that retirees who own traditional IRAs begin taking distributions right around age 73 or 75, yet because these distributions are added to taxable income, it pushes many people into higher tax brackets. Additionally, since Roth IRAs do not have RMD requirements, Roth IRAs offer retirees greater flexibility when managing their tax situation.

Finally, Roth IRAs can be an excellent vehicle for clients who want to leave a financial legacy. Roth IRA beneficiaries continue to enjoy tax-free withdrawals, although they are subject to the 10-year rule under the SECURE Act, which mandates that the account be emptied within 10 years of the original owner’s death.

Gauging the ideal timing for Roth conversions

Converting to a Roth IRA cannot be a snap decision. Strategic timing is needed to maximize benefits and minimize tax burdens.

One optimal time for conversions is during lower-income years. For many clients, this occurs after they retire but before they begin taking Social Security or other significant income streams. Converting in these years can help ensure your clients remain in lower tax brackets and can minimize their tax hit from the conversion.

Another opportune moment for a Roth conversion is during market downturns. Converting during a dip means transferring assets at a lower value and reducing the tax bill. As the market recovers, your clients’ assets can then appreciate in the tax-free environment of the Roth IRA.

Due to recent tax legislation, current tax rates are relatively low, so many of our clients will find it prudent to perform conversions now. I say this in anticipation of possible higher tax rates after 2025 when provisions of the Tax Cuts and Jobs Act are set to expire unless extended by new laws.

Assessing the tax considerations with a Roth conversion

While a Roth conversion can be incredibly beneficial in the long run, we must remind clients about the immediate tax implications. When we help clients convert from a traditional IRA to a Roth IRA, the amount we convert is treated as taxable income, potentially increasing our clients’ tax bills that year. However, we can guide them on strategies to minimize these tax burdens.

As financial advisors, we can counsel our clients to spread their conversions over several years to avoid being pushed into higher tax brackets. This strategy, often called “partial conversions,” allows for a more manageable tax burden each year.

Converting just enough each year to “fill up” the lower tax brackets without pushing the client into a higher bracket — for example, converting up to the top of the 24% tax bracket if it makes sense for the client’s situation — is an effective strategy.

Calculate the tax impact precisely and strategically decide how much to convert each year. For your clients over age 59½, consider using existing retirement funds to pay the taxes. This allows more of the converted amount to remain in the Roth IRA.

To offset the tax implications of a Roth conversion, take advantage of years when your client can leverage significant deductions or tax credits. Large out-of-pocket medical expenses, business losses or charitable contributions can mitigate the immediate tax impact of the conversion.

It’s also important to consider the conversion’s impact on other taxes and benefits. For example, converting large amounts could increase the taxation of Social Security benefits or raise Medicare premiums due to higher reported income.

Long-term planning strategies

A strategic Roth conversion involves more than immediate tax considerations. It’s part of a broader long-term tax planning strategy.

By performing Roth conversions, our clients can reduce the size of their traditional IRAs, enabling them to lower their future RMDs. This can be particularly beneficial for those who anticipate being in higher tax brackets in retirement due to substantial RMDs, Social Security benefits or other income sources.

A key tenet of long-term strategic tax planning is tax diversification. Having assets in a mix of taxable, tax-deferred and tax-free accounts gives clients more flexibility in managing their tax situations in retirement. Roth IRAs play a crucial role in ensuring this diversification, allowing our clients to withdraw from tax-free sources when it’s most advantageous.

Under the income-related monthly adjustment amount, our higher-income clients face increased Medicare premiums. However, by using Roth IRAs, they can reduce their modified adjusted gross income and avoid higher premiums.

Avoiding common mistakes when converting

While Roth conversions offer several benefits for our clients, they also present several pitfalls. One of the most common mistakes our clients make is not considering future tax rates. 

If a client’s future tax rate is expected to be lower than their current rate, a conversion may not make sense. However, many clients — especially diligent savers — may find themselves in similar or higher tax brackets in retirement
due to RMDs, Social Security and other income sources. 

The second common mistake is ignoring the Medicare premium surcharge. Conversions can impact Medicare premiums, and higher reported income can trigger a premium surcharge, increasing the cost of Medicare Parts B and D. Therefore, it’s essential to plan conversions to avoid or minimize these surcharges whenever possible.

A third error involves overlooking state taxes, which can also affect the cost of Roth conversions. Some states do not tax retirement account distributions, while others do, so financial advisors must consider the client’s state tax situation as part of the conversion strategy.

An additional error to watch for is failing to plan for RMD integration. Our clients often overlook how Roth conversions interact with their RMD strategy. With this in mind, we must educate our clients that RMDs from traditional IRAs must still be taken for the year of conversion if they are already subject to RMD rules.

Don’t allow your clients to neglect to check for contradictory penalty assumptions. If they are under age 59½, using funds from the converted IRA to pay taxes might incur a 10% penalty on early distributions.

Another frequent mistake involves overconversion. Converting too large an amount in one year can push our clients into higher tax brackets, negating some of the conversion’s strategic benefits. Advisors should emphasize the importance of partial conversions and the potential to spread them over multiple years.

A final mistake I will mention is failing to plan for the widow’s penalty. When one spouse passes away, the surviving spouse files as a single taxpayer, often resulting in higher tax rates on the same income level. Planning conversions while both spouses are alive mitigates the risk of incurring this penalty.

So as we help our clients fight for the worry-free retirement they deserve, Roth IRA conversions can be a key component in our strategic tax planning. They offer the one-two punch of tax-free growth and withdrawals in retirement.

Before converting, we empower clients to consider tax implications, other taxes and benefits, and potential future changes in tax laws. We help them time their conversion during lower-income years or market downturns to minimize their immediate tax impact. Additionally, our long-term planning strategies, such as reducing RMDs and ensuring tax diversification, arm them with greater financial stability and flexibility.

As financial advisors, we save more than the day. We save years for our clients, guiding them through a minefield of complex decisions that ultimately ensure a more secure and tax-efficient retirement.