Readers of “a certain age” may remember a television ad that was popular some years ago. The product was a well-known automobile oil filter intended to extend engine life. The message of the ad was that paying a little more now—by using the advertised filter instead of a “bargain brand”—could reduce the likelihood of future car problems and major expenses. At the end of the ad, the speaker, dressed like a car mechanic, looks at the camera and says, “You can pay me now—or you can pay me later.”
It may not be too surprising to learn that the IRS has a similar message concerning tax-advantaged retirement accounts. Like the commercial, taxpayers have a choice between paying a little more now, or potentially paying a lot more later.
The “pay me later” version can happen when taxpayers have most or all of their retirement savings in traditional (pre-tax) IRAs, 401(k)s, or 403(b)s. Because traditional accounts are pre-tax, the taxpayer is allowed to deduct contributions to the account from current taxable income, which can feel pretty good in the current year. But later, in retirement, when many taxpayers have access to fewer deductions, all of the withdrawals from the traditional accounts are taxable as ordinary income. Not only that, but because of required minimum distributions (RMDs), they must withdraw a certain amount from the accounts each year, whether they need the income or not.
The alternative—the “pay me now’ version—is represented by converting a traditional, pre-tax account to a Roth (after-tax) IRA. The taxpayer does not get a deduction from taxable income for direct contributions to a Roth, and they will pay taxes at current income rates on any amounts converted to Roth status from a traditional account. But later, in retirement, withdrawals from the Roth account are not taxed as ordinary income, and because there are no RMDs with Roth IRAs, the taxpayer has control over when—or if—withdrawals are made.
Roth conversions and current income tax brackets
Because of these advantages, some taxpayers may benefit by converting traditional accounts to Roth accounts. But, because Roth conversions create taxable events (the transferred amounts must be converted from pre-tax to after-tax, which means paying taxes on the amount transferred), timing is very important. On the other hand, a Roth conversion can be a great way to create more tax-free income in retirement, even for those whose income may prevent them from contributing directly to a Roth IRA (employer plans like 401(k)s and 403(b)s are generally exempt from such income restrictions for contributors).
Timing and Roth conversions
To get the maximum benefit from a Roth conversion, then, it’s best to take advantage of periods when you may be in a lower tax bracket, because your tax bracket at the time of the transfer determines how much you will pay on the conversion. This means that when you’re considering a traditional-to-Roth conversion, you need to consult with your tax and financial advisors and do a careful analysis to make sure the conversion makes sense, both in terms of your current tax situation and for efficient retirement income planning.
Several things should be considered. First, remember that any amounts converted from a traditional account to a Roth account will be considered as taxable income. So, if your income before the conversion is close to moving you into a higher bracket, the conversion could push you over the line, creating extra tax liability. In such a case, you may not wish to convert the full amount of the traditional account in a single year, thus limiting your tax liability. By spreading the conversion out over several years, you may be able to pay less in taxes and, at the same time, create a larger tax-free income stream in retirement.
Another factor to consider is market pricing. In years when the market has been difficult, you are likely to have fewer capital gains to report. This can put you in a lower overall tax bracket, possibly creating an opening for paying less in taxes on a Roth conversion and setting up the converted funds for tax-free growth when markets are more favorable.
You’ll also want to be sure all of your retirement accounts have been considered. Don’t assume an individual IRA can be viewed in isolation; other Traditional, SEP, and SIMPLE IRA balances may significantly impact the tax consequences of a Roth conversion.
What is the five-year rule for Roth conversions?
A five-year holding period applies to withdrawing earnings on the funds that are held in a Roth IRA account. In order to withdraw earnings, the Roth account needs to be open for at least 5 years. The timing of this is 5 years from the year the account is opened. This determines the taxability of any Roth earnings withdrawals.
The other question is whether Roth withdrawals are subject to penalties on the earnings portion. A qualified distribution, such as withdrawals after age 59.5, are generally exempt from penalties. Still, if the account hasn’t reached the aging requirement of 5 years, earnings can be taxed while still exempt from additional penalties.
For Roth conversions, the tax is generally paid at the time of conversion. A separate five-year rule applies to converted amounts and determines whether withdrawals of converted principal are subject to the 10% early distribution penalty. Generally, taxpayers under age 59½ who withdraw converted amounts within five years of the conversion may be subject to the penalty, even though the amount withdrawn is not taxed again. Taxpayers age 59½ or older are generally exempt from this penalty. However, the separate five-year aging requirement for Roth IRAs still determines whether Roth IRA earnings may be withdrawn tax-free.
How do Roth conversions affect Medicare premiums?
Another potential advantage of Roth conversions is their potential to help retired taxpayers reduce the income-related monthly adjustment amount (IRMAA) surcharge on the premiums they pay for Medicare Parts B and D. IRMAA is an extra charge added to the monthly premiums for Medicare Part B and Part D if the taxpayer’s modified adjusted gross income (MAGI) from the two prior years exceeds certain amounts. In other words, the higher your MAGI, the more you are likely to pay in IRMAA surcharges.
Because RMDs from traditional retirement accounts are included as part of MAGI, they can contribute to pushing retired taxpayers into a higher bracket for IRMAA. But because Roth IRAs have no RMDs, taxpayers who don’t require the income can simply leave the funds in their Roth accounts, potentially reducing their RMDs and giving them greater control over their MAGI and, thus, their exposure to IRMAA surcharges.
At The Planning Center, we can work with clients to take a longer view of their tax strategy and help them decide if it makes sense to pay a little more now in order to save on taxes later. If you’d like to see how this strategy could apply to you, please give us a call.
What’s the difference between tax preparation and tax planning?
