Authored by Douglas Richardson
With tax reform still in limbo, 2018 may offer a great opportunity to convert a traditional individual retirement account (IRA) into a Roth account.
The main distinction between a traditional IRA and a Roth IRA is the timing of when the taxes are paid on the funds either contributed or withdrawn from the plan. Traditional IRAs are funded with pre-tax dollars which allow for tax-deferred contributions but result in taxation on all distributions. Roth IRAs are funded with after-tax dollars and allow for tax-free distributions, including any growth that took place within the account.
Funding a Roth IRA can be difficult for high-net-worth taxpayers due to income limits ($196,000 modified adjusted gross income for married filing joint taxpayers), however, there is no income limit on a Roth conversion.
Currently, the top federal individual income tax rate is 39.6 percent. Tax reform proposals released by the White House and Congress, both have the top individual rate being reduced to 35 percent. If top federal rates are reduced for the 2018 tax year, then depending on a taxpayer’s facts and circumstances, converting all or a portion of a traditional IRA to a Roth IRA could be an opportunistic tax planning strategy.
This planning strategy works best for taxpayers with the following characteristics:
- Currently in the highest income tax bracket
- Funds in traditional IRA assets
- Cash on hand from other sources to pay the tax on conversion
- Expect to be in the highest tax bracket in retirement
- No distributions expected to be made in the immediate future (as portrayed in the below example the savings compound the longer the funds can grow tax free)
According to several prominent Republicans in Washington, by using budget reconciliation, tax reform may not need to be revenue neutral in order to pass; Republicans may be able to pass tax reform with a simple majority vote. However if the proposed bill alters revenues over a 10-year time period, then under the Byrd Rule, tax rates will need to sunset over the same time frame. If tax reform is passed via budget reconciliation then any tax cuts will reset to the current rates, much like what happened to the Bush tax cuts in 2010.
Converting a traditional IRA to a Roth IRA, tax is paid on the balance of the account that was funded and grew as a result of pre-tax dollars. If under age 59.5, there is no 10 percent early withdrawal penalty for converting a traditional IRA to a Roth IRA. Depending on the resident state, taxpayers will need to consider the state tax implications of making a Roth conversion.
Assuming tax reform reduces the highest federal rate to 35 percent and resets to 39.6 percent in retirement, the following example illustrates the potential savings on conversion:
|Age when distributions begin||70|
|Number of years until distributions begin||20|
|Average annual percentage return||6%|
|Reduced federal income tax bracket||35%|
|Expected federal income tax bracket in retirement||39.6%|
|Current IRA balance||$500,000|
With the above assumptions, a taxpayer would need $175,000 (500,000 x 35%) available outside of the IRA in order to pay the federal tax to convert the traditional IRA to a Roth IRA.
IRA conversion analysis
|Pre-conversion||Traditional IRA||Roth IRA|
|Current IRA balance||$500,000||NA|
|Roth conversion amount||NA||$500,000|
|Account balance at retirement in 20 years after conversion|
|Estimated IRA balance||$1,603,571||NA|
|Estimated side account||$376,140||NA|
|Estimated Roth IRA amount||NA||$1,603,571|
|Estimated value at retirement (before taxes)||$1,979,711||$1,603,571|
|Annual after-tax distribution|
|After tax income||$84,443||NA|
|Side account income||$26,763||NA|
|Roth IRA income||NA||$139,807|
|Total annual after-tax income||$111,207||$139,807|
As illustrated in the above example, if rates decrease to 35 percent and a taxpayer has the ability to pay the federal tax with funds outside the IRA, there is an opportunity to significantly increase after-tax income in retirement when rates are again expected to increase to 39.6 percent. If rates during retirement exceed 39.6 percent or the number of years before taking distributions can be deferred, the after-tax savings will only be larger.
When determining if this strategy makes sense, you need to weigh the following advantages and disadvantages of conversion:
- All future distributions will be tax free
- Paying federal tax at the lower rate of 35 percent
- Not required to take required minimum distributions at age 70.5
- Use of funds outside of the IRA to pay the tax on conversion (must weigh the time value of money and opportunity cost of using these funds to pay the tax versus having them available for other investments)
- Having to prepay state income taxes (depending on the resident state)
The conversion to a Roth IRA has a built-in safety net. IRS rules allow taxpayers to recharacterize a conversion. In other words, a taxpayer has the flexibility to reverse the conversion from a Roth back to a traditional IRA up until the time the taxpayer’s return is filed (including extensions) without incurring any tax or penalties. So if a taxpayer decides to make a conversion in January 2018, he or she would have until October 2019 to decide if he or she wants to keep the election in place.
This has two essential benefits:
- If tax rates do not decrease, the election can be reversed and the taxpayer can wait to see if tax reform takes place
- If the traditional IRA loses value over the above illustrated time frame, the election can be reversed in order to avoid paying tax on the previously higher value in the account
When determining if a Roth conversion makes sense, taxpayers need to look at specific facts and circumstances to see if it would be a valuable tax planning strategy for them.
For more information on this topic, or to learn how Baker Tilly tax specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.