What advisors and clients must know about Roth conversions

Roth conversions are among the most popular retirement planning strategies, but the rules surrounding them are increasingly complex.

Jay Kautt, vice president, advanced markets at Athene USA, gave an update on Roth conversions, Roth IRA rules and the planning considerations for financial professionals during a recent webinar for the National Association for Fixed Annuities.

Roth conversions can be defined as moving money from a traditional individual retirement account to a Roth IRA, Kautt said. Income tax will be due on the amount converted. There are no income limits for Roth conversions, and either the full amount or a partial amount of the traditional IRA can be converted into a Roth IRA.

Three key considerations on whether a client should do a Roth conversion are:

1. When will the money be needed? It’s recommended that a minimum of 10 to 15 years pass between converting the IRA and withdrawing the funds.
2. What will future tax rates be when compared with current tax rates and income?
3. Are funds available to pay the tax on conversion? The best practice is to pay the tax from non-IRA funds.

The backdoor Roth IRA is a strategy for higher earners who are not eligible to contribute to a Roth IRA. Kautt said that in the backdoor strategy, the taxpayer makes a nondeductible, after-tax contribution to a traditional IRA and then converts to a Roth.

Advisors and their clients must beware of the pro-rata rule, he said. The rule applies when a taxpayer has pretax and after-tax dollars in traditional IRAs. The IRS treats all IRAs as one bucket for Roth conversion purposes. The IRS does not allow a taxpayer to isolate only the after-tax dollars in an IRA when completing a Roth conversion. Income tax is due on the proportion of the conversion that contains pretax dollars.

Two rules for distributions

Two separate 5-year rules governing Roth IRA distributions also must be considered by advisors and clients, Kautt said.  They are the 5-year rule for penalty-free distributions and the 5-year rule for tax-free distributions.

The 5-year rule for penalty-free distributions applies only to the penalty and not the tax. It applies if the Roth holder is younger than age 59 ½, and it applies only to conversions. This rule states that if the converted funds are not held for at least five years or until age 59 ½, any withdrawal before that time is subject to a 10% penalty – the same as it would if the holder were to take money from their traditional IRA. Each conversion has its own 5-year holding period, and the 5-year holding period begins on Jan. 1 of the year in which the conversion was made.

The 5-year rule for tax-free distributions applies only to income tax and not penalty. Under this rule, the 5-year period starts when a taxpayer’s first Roth IRA is established and does not start over for each subsequent Roth IRA contribution or conversion. The holding period begins on Jan. 1 in the year in which the first taxpayer’s Roth IRA is established.

“That’s why we encourage folks to start the clock in their 20s, 30s or 40s, so that when we get to age 59 ½, we don’t have any issues,” Kautt said.

He gave the example of a 65-year-old client who just retired and never had a Roth IRA. They began converting at age 65 to establish their first Roth IRA. They don’t intend to touch the money, “but sometimes stuff happens,” he said.

“The establishment of that Roth IRA at age 65 starts the 5-year clock. That client, even though they are over age 50 ½, cannot access the earnings in that Roth IRA free of tax until they hit age 70,” he said. “Five years and age 59 ½ - you need to hit both.”

Impact of the One Big Beautiful Bill Act on Roth conversions

The One Big Beautiful Bill Act is approaching the first anniversary of its passage, and it has implications for Roth conversions.

OBBBA increased the state and local tax deduction from $10,000 to $40,000. However, that deduction begins to phase out when a taxpayer reaches $500,000 of modified adjusted gross income and reaches a floor of $10,000 when MAGI hits $600,000 or higher. A Roth conversion adds dollars to a taxpayer’s MAGI in the year when the conversion is made, and this could impact a taxpayer’s ability to claim the SALT deduction, Kautt said.

However, he added, for clients who are younger or don’t intend to use the money in their Roth IRA, years of tax-deferred growth along with a qualified tax redistribution down the road may offset the loss of income and subsequent tax increase that they incurred when converting to a Roth.

Additional Roth IRA opportunities

A 529 plan can be rolled over to a Roth IRA but SECURE 2.0 placed some restrictions on that rollover, Kautt said.

The 529 plan must have been open for 15 years and the eligible rollover amount must have been in the plan for at least five years. The annual rollover limit is $7,500 a year and the lifetime rollover limit is $35,000. Rollovers must be made to a Roth IRA owned by the 529 plan’s named beneficiary.

Another strategy is the mega backdoor Roth IRA. Kautt described it as a strategy for those with a 401(k) plan that allows for after-tax contributions. To be eligible for this strategy, the individual must participate in the 401(k) plan and the plan must allow an in-service distribution to a Roth IRA or transfer of funds from the after-tax portion to a Roth 401(k).

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