Welcome to another episode of the Wealth Breakdown Podcast! In this article, we’ll break down a practical case study on Roth IRA conversions. We’ll discuss when it makes sense, the advantages of Roth IRAs, and strategies to help you maximize the benefits. Whether you're a taxpayer or a financial professional, this guide will help you determine if a Roth conversion aligns with your goals.
What is a Roth IRA Conversion and Why Does it Matter?
A Roth IRA conversion involves moving funds from a traditional IRA to a Roth IRA. While this process triggers immediate taxable income, it offers significant long-term benefits, such as:
Tax-Free Growth: Roth IRAs provide tax-free growth rather than tax-deferred growth.
No Required Minimum Distributions (RMDs): Unlike traditional IRAs, Roth IRAs don’t require minimum distributions at age 73.
Tax-Free Withdrawals for Beneficiaries: Heirs can withdraw funds tax-free after the owner’s death.
Estate Planning Advantages: More effective funding of bypass trusts and strategic wealth transfers.
Income Smoothing: Helps reduce future taxable income and minimize the 3.8% Net Investment Income Tax (NIIT).
However, whether a Roth conversion is beneficial depends on your specific situation, particularly your current and future tax rates.
Key Factor: Comparing Tax Rates
The decision to convert largely hinges on comparing your marginal income tax rate at the time of conversion with your expected tax rate during retirement:
If your current tax rate is lower than your future tax rate, a Roth conversion can provide significant economic benefits.
If your current tax rate is much higher, it may make sense to hold off on converting.
If the rates are slightly higher now, special factors may still make a Roth conversion worthwhile.
Let’s dive into a case study to illustrate this concept.
Case Study: Wilma’s Roth IRA Conversion
Background
Wilma is a single taxpayer in a 40% combined federal and state income tax bracket.
She has $1 million in a traditional IRA.
She also has $400,000 in liquid assets in a taxable account (side fund) that can be used to pay conversion taxes.
Over the next 30 years, Wilma expects the IRA to grow by 300% and the side fund to grow by 200% (due to taxation on the taxable account).
At retirement, Wilma will remain in the 40% tax bracket.
Terminal Wealth Scenarios
No Conversion (Traditional IRA): Wilma leaves her assets in the traditional IRA. The total terminal wealth is $3.6 million.
Roth Conversion (Taxes Paid from IRA): Wilma converts to a Roth IRA but uses IRA funds to pay the taxes. The terminal wealth remains $3.6 million.
Roth Conversion (Taxes Paid from Side Fund): Wilma converts to a Roth IRA and uses the taxable account to pay the taxes. The terminal wealth increases to $4 million.
Key Takeaway
By using outside funds (the side fund) to pay the conversion taxes, Wilma effectively moves more money into the Roth IRA. This results in an additional $400,000 of tax-free wealth.
Additional Factors Favoring a Roth IRA Conversion
While the tax rate comparison is crucial, several special factors can further support a Roth conversion:
Favorable Tax Attributes
Carryforward net operating losses (NOLs) can offset the taxable income generated by a conversion.
Charitable deduction carryforwards and investment tax credits can reduce conversion-related taxes.
High-basis, non-deductible traditional IRAs may result in a lower taxable conversion amount.
Estate Planning Benefits
Roth IRAs avoid RMDs, allowing assets to grow tax-free and transfer to heirs efficiently.
Paying income tax before estate tax reduces the overall estate tax burden.
Tax Bracket Management
Married couples often benefit from lower tax brackets. If you plan to get married, waiting to convert could save on taxes.
Conversions can be structured in stages to “fill up” lower tax brackets without pushing income into higher brackets.
Net Investment Income Tax (NIIT) Mitigation
Traditional IRA distributions increase Modified Adjusted Gross Income (MAGI), which can trigger the 3.8% NIIT.
Roth IRA distributions are excluded from both net investment income and MAGI, helping you avoid or reduce NIIT.
Strategic Approaches to Roth IRA Conversions
Roth conversions can be categorized into four key strategies:
Strategic Conversions: Align with long-term wealth transfer objectives and estate planning goals.
Tactical Conversions: Take advantage of short-term opportunities, such as low-income years, tax credits, or carryovers.
Opportunistic Conversions: Convert during stock market downturns to capitalize on temporarily reduced asset values.
Hedging Conversions: Protect against future higher tax rates by locking in current lower rates.
Example: Avoiding NIIT with Roth IRA Distributions
Consider a taxpayer filing single with the following income:
Salary Income: $100,000
Dividend Income: $100,000
The taxpayer avoids NIIT because their Modified Adjusted Gross Income (MAGI) doesn’t exceed the applicable threshold. However, if they take traditional IRA distributions, their MAGI could increase, triggering the 3.8% NIIT. Roth IRA distributions, on the other hand, don’t impact MAGI or NIIT.
Income Smoothing with Roth Conversions
Taxpayers expecting higher income in the future can “smooth” their taxable income by converting in stages. This prevents large tax spikes and ensures conversions stay within lower tax brackets.
Is a Roth IRA Conversion Right for You?
Roth IRA conversions offer numerous benefits, but they require careful analysis of tax rates, income levels, and long-term goals. Factors like carryforward losses, estate planning, and NIIT mitigation can further enhance the value of a conversion.
If you’re considering a Roth conversion, consult with a financial planner or CPA to evaluate your specific situation. Tools and strategies are available to help you maximize the benefits while minimizing tax liability.
Stay tuned for the next episode of the Wealth Breakdown Podcast!
Want to learn more? Check out these other articles from Bloomwood!
Roth Conversions Primer: https://www.bloomwoodcapital.com/post/roth-conversions-primer
Disclosures
Bloomwood does not make any representations as to the accuracy, timeliness, suitability, or completeness of any information prepared by any unaffiliated third party, whether linked to or incorporated herein. All such information is provided solely for convenience purposes and all users thereof should be guided accordingly.
We are neither your attorneys nor your accountants and no portion of this material should be interpreted by you as legal, accounting, or tax advice. We recommend that you seek the advice of a qualified attorney and accountant.
For additional information about Bloomwood, please request our disclosure brochure as set forth on Form ADV using the contact information set forth herein, or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov). Please read the disclosure statement carefully before you engage our firm for advisory services.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Bloomwood is a registered investment advisor. Advisory services are only offered to clients or prospective clients where Bloomwood and its representatives are properly licensed or exempt from licensure. 730 Starlight Lane, Atlanta, GA 30342.
Comments