The tax laws changed for taxable years after 2017 regarding allowing recharacterization — or, in simple terms, being able to undo a Roth conversion. Since you are no longer able to undo a conversion there are some important considerations to make before taking this route since it can impact your tax situation and potentially push you into a higher income tax bracket for Medicare.
What is a Roth Conversion?
A Roth conversion is taking funds from a regular IRA account, paying taxes on the income since the funds are pretax, then moving them to a Roth account. The funds grow tax-free in the IRA account, and since the taxes were already paid, you owe no taxes when you withdraw the funds. This is best executed while you are in a lower tax bracket (usually after retirement but prior to taking social security and required distributions from any traditional IRAs). Keep in mind you cannot convert funds from an inherited IRA.
The main advantage of a Roth is the funds are not taxable when you take them out later on which may possibly lead to lower taxes in future. You then have the flexibility to use Roth funds to subsidize higher expense years vs. taking excess from an IRA assuming the bulk of your funds are in a retirement account. This is a great strategy for people with larger IRAs since they can convert funds when they are in a lower tax bracket, usually after retirement and before age 72 (previously age 70.5 before the new tax law changes which extended the required distribution age to 72), and create an account which grows tax-free but is no longer taxed when withdrawals are made.
How much is the Roth conversion going to cost?
The question is whether you think you will be in a higher tax bracket now vs. later. If your tax bracket will be lower later in life, then you would lose some of the benefits. If you plan to move from a lower-tax state such as Florida to a higher-tax state such as California, converting funds before moving may make sense since you would avoid state taxes. Hedging against future higher taxes can be a crapshoot since nobody really knows what rates will be in the future.
Pension income, social security income, and IRA distributions may push you into a higher bracket for Medicare (IRMAA). Since Roth accounts have no required minimum distributions, this can automatically lower your taxes in the future and can be beneficial when it comes to staying in a lower Medicare bracket.
Do you have other after-tax funds?
If you plan to spend more than your retirement income and minimum IRA distribution but have other after-tax funds, a Roth account may be less beneficial since you can still avoid having to take excess funds from your IRA. However, if you have high unrealized gains in the after-tax account, you may be forced into a higher tax bracket anyway by taking the gains when funds are needed.
Do you plan to leave funds to heirs tax-free?
Leaving Roth money to heirs can be very helpful to them in future, especially if you have high-income children. Having to take mandatory distributions out of an inherited IRA will incur additional income. This is especially important to note now that the SECURE Act has changed the distribution rules from inherited IRAs to having to liquidate the account within 10 years vs. using life expectancy.
If you have named a trust as the beneficiary of your IRA, a trust has higher tax rates and required distributions to the trust are tax-free with an inherited Roth in comparison to a regular inherited IRA owned by the trust.
Will you have future tax deductions?
If you already have a large Roth, it may make sense to keep some funds in a regular IRA so you have flexibility to take advantage of future tax situations. For example, if you foresee any possible ability to offset losses or deductible expenses, you may be able to pay no taxes on a conversion. One possible situation is a large medical expense deduction when purchasing into an assisted living facility. This would cause a large up-front medical deduction, which can offset the excess income in that year.
Feel free to reach out to Roxanne Alexander with any questions by email: RAlexander@Evensky.com or phone 305.448.8882 ext. 236.