Roth Conversions: Should You Make the Move?

Before diving into the topic, it is important to disclose that we here at Northern Alliance Financial are financial advisors, not accountants. We do not give tax advice. If a client is interested in doing a Roth conversion, we typically work hand in hand with their accountant, so all are on the same page prior to moving forward with any Roth conversion plan.

Many of you may say, “Well, I don’t even have a Roth, so what is it and why should I care?”

The Roth is, arguably, one of the most unique and powerful investment tools that exist in the world of finance today.

Why? Because once your funds are in a Roth, they enter into a ‘tax-never’ bucket. In other words, any growth or ‘gains’ within the account are NEVER subject to taxes again. This is true, not only for you, but also for your beneficiaries!

Wait…what does that mean?

Let’s walk through an example: Let’s say you have $100,000 in a traditional (‘qualified’ or pretax) IRA. When you pass away, the assets in that account are transferred to your designated beneficiary. From there, the beneficiary would be identified based on your designations to determine where the funds should be transferred.

When it comes to inheriting IRA funds, the rules differ depending on whether the beneficiary is a spouse or not, as spouse vs. non-spouse beneficiary rules have changed under SECURE Act 1. and 2. For spouses, there are no large changes to spousal inheritance of a qualified account. A surviving spouse can generally assume the IRA as their own, and would have to take RMDs (Required Minimum Distributions) just as they would normally.

For non-spouse beneficiaries, however, there was a significant change under the SECURE Act. Prior to the passage of the Secure Act, a non-spouse beneficiary could inherit an IRA (qualified/pre-tax) and “stretch” over the course of their projected lifespan, irrespective of their age. In other words, the funds in the inherited IRA could be ‘stretched’ – so they could receive a portion for the remainder of their lives, even if they were only 20 years old when they first inherited it!

Congress didn’t like this rule…so they decided to change it.

Why? So they could get the taxes from the funds sooner, of course! With the passage of the Secure Act, congress effectively reduced the “stretch” from a projected life-span to 10 years. This means, if a 20 year old non-spouse inherits an IRA, they are required to withdraw the entire balance of the inherited IRA within 10 years.

These funds are all taxable to the recipient. They have the choice on ‘how’ to drain the funds (typically 1/10th per year but the funds all must come out of the inherited or beneficiary IRA by the end of the 10 year period.

What if the funds were not in an IRA but had been converted to a Roth?

The SECURE ACT rules still apply for the non-spouse. The non-spouse beneficiary must withdraw the funds within 10 years. So, what is the advantage to a Roth? The advantage is – when they withdraw the funds, they pay zero” taxes on any funds withdrawn! Why? Because the funds came from a ‘tax-never’ Roth account. Therefore, a Roth Conversion becomes a very significant legacy planning tool.

Additionally, with the passage of the Tax Cuts and Jobs Act (first introduced during the Trump Administration and recently extended), taxes were reduced in five of the seven Marginal Tax Rate brackets. This created some of the lowest federal tax rates we’ve seen in 40 years.

What does this mean in terms of Roth conversions?

Well, we know that taxes are the lowest they’ve been in over 40 years. This also means that, most likely, taxes will increase in the future. If you know you have money in a qualified/pre-tax account that you will, eventually, have to take out and pay taxes on …why not take advantage of the low tax rates now and convert some to a Roth?

What if you don’t have a Roth account?

We here at Northern Alliance Financial can create one for you!

Another hypothetical example: let’s say you’re 69 years old and have $400,000 in a traditional/pretax IRA. After analysis with your accountant, we were able to determine that we could ‘convert’ $25,000 per year to a Roth for the next 4 years and still stay within the same tax bracket.

What have we just done? Well, several things:

1. We have moved $100,000 of money out of your taxable/pretax account into a Roth, thereby reducing the RMD base amount from $400,000 to $300,000.

2. We have established a $100,000 ‘tax-never’ Roth account that you do not have to take RMDs from.

3. The $100,000 Roth account also is a legacy planning tool, as those funds will be inherited tax-free to the recipients.

4. We did this all while staying in the same marginal tax rate.

There are lots of other things we need to think about when doing or considering these conversions. With the extension of the Tax Cuts and Jobs Act and the current lowered tax-rate environment, it is definitely worth looking into with your advisor and accountant to identify if a Roth Conversion should be part of your financial planning process.