Planning Opportunities to Consider Before Year-End Part 3 – Roth IRA Conversions

Determining the opportune time to scrutinize your Individual Retirement Account (IRA) for a potential Roth conversion is an intricate task.

As you may know, Roth IRA accounts grow tax-free, distribute tax-free and are not subject to required distributions later in life. The recent volatility of equity markets can make timing Roth conversions confusing, but catching the down swing of investment value with a Roth conversion can be a window of opportunity to consider.

The funds within your IRA have undergone tax-deferred growth since your initial contribution. Acknowledging that these funds are destined for taxation in the future at your anticipated tax bracket, contemplating a Roth conversion becomes meritorious, particularly if your prevailing tax bracket today is lower than the anticipated future brackets.  This is especially germane for individuals who retire prior to initiating Social Security retirement benefits and before the imposition of mandatory IRA minimum distributions (RMD) at their required age.

So, what exactly constitutes a Roth conversion? In essence, it is the process of transferring assets from a traditional IRA (or an employer-sponsored plan such as a 401(k), 403(b), or 457 plan) to a Roth IRA. The transferred amount becomes taxable income to you in the year that you convert – thus necessitating additional tax payment in the year of conversion. Once funded in the Roth IRA, these assets are afforded the privilege of continued tax-deferred growth (not subjected to Fed or State taxes) and, significantly, can be cashed out or distributed income tax-free – as well as inherited tax free, too.

The question of whether a Roth conversion is a judicious undertaking is contingent upon various factors. A pivotal advantage of executing a Roth IRA conversion lies in its potential to mitigate future income taxes by allowing the individual with the discretion to opt for taxable or tax-free distributions. A comprehensive income planning strategy, with a bit of tax guidance on the trajectory of your income tax bracket throughout retirement is imperative to contextualize the advantages of a Roth IRA conversion.

For certain individuals, Roth conversions may not yield substantive benefits during their lifetimes. Conversely, for those possessing the financial means to settle the Roth conversion based income taxes, and whose retirement income remains largely unaffected by such conversions, the focus may pivot towards legacy considerations. The allure of tax-free Roth IRA assets bequeathed to heirs contrasts sharply with the tax implications of traditional IRA assets, which, under prevailing tax laws, are slated for taxation within ten years of inheritance. Essentially, the choice boils down to settling the taxes on your IRA during your lifetime or bequeathing the tax burden to your children within a decade of inheritance, making tax-free Roth IRA assets a more appropriate bequest, if attainable.

While the conversion of a specific dollar amount from your IRA to a Roth IRA in the backdrop of choppy or down markets may be perceived as a tactical maneuver, it also foreshadows strategic wisdom for five other compelling reasons:

1. IRMAA (Income-Related Monthly Adjustment Amount): For individuals under 65, Roth conversions may serve as a preemptive strategy to mitigate exposure to IRMAA in later years when additional Medicare-related premiums may become exigent based on the level of your adjusted gross income.  The IRMAA tax is a cliff tax – so you need only to go one cent over the bracket threshold and then end up paying more into the next highest bracket without exception.
2. Income Tax Bracket Planning: Anticipating a lower-than-typical tax bracket for 2023 due to time off or employment hiatuses provides an opportune moment to capitalize on filling up lower tax brackets by converting IRA assets to a Roth IRA. The conventional assumption of entering a lower tax bracket in retirement is not universally applicable, especially for those with substantial retirement assets, as the onset of mandatory distributions at age 72 (or later depending your RMD age) may catapult them into higher tax brackets for the rest of their lives.
3. Ordinary Losses: If ordinary losses are foreseen in your 2023 tax filing, these losses can offset, dollar for dollar, any reportable income from Roth IRA conversions before December 31st. Business owners with historical loss carry-forwards should consult their tax professionals to determine the applicability of this strategy. A key benefit of the ordinary loss and converting IRA dollars to match that amount means there’s no additional out-of-pocket amount needed to be paid for the conversion.
4. Flexible Distributions: The coexistence of funds in a Roth IRA alongside a traditional IRA provides enhanced flexibility for meeting retirement cash flow needs. The ability to draw from a tax-free reservoir (Roth IRA) in conjunction with a taxable source (IRA) facilitates heightened levels of tax and income optimization based on individual circumstances.
5. RMD Freedom: Freedom isn’t free, per se, but it does alleviate the tax burden later on in life. Roth IRA dollars enjoy exemption from the IRS Required Minimum Distribution (RMD) rules at various older ages of 72 and older, in stark contrast to their traditional IRA counterparts.

We contend that Roth IRA conversions warrant serious consideration in the realm of retirement planning. The viability of this strategy hinges on individual circumstances.

For further clarification or inquiries, we encourage you to engage with your ACM Wealth Advisor, who can expound on whether a Roth IRA conversion aligns with your financial goals.

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