The Power Of Roth Conversions (And Why The New Tax Law Is A 7-Year Gift)

Perhaps no other retirement planning tool or strategy has the potential to be as powerful for pre-retirees, and even recent retirees, as Roth conversions. There is a lot of confusion surrounding Roth conversions, but the rules are actually pretty straightforward (and much less complicated than Roth IRA contribution rules and regulations). A Roth conversion is simply the change made to a tax-deferred retirement account that moves money from tax-deferred status in the eyes of the IRS to taxable-this-year status. It is essentially a bookkeeping entry or an accounting reclassification. Once the conversion occurs, the funds and all future growth are tax-free.

Most Americans have been trained to defer the taxes on their retirement savings for as long as possible in the (often mistaken) belief that they will be in a lower tax bracket when they retire. I say “often mistaken” because it is common for retirees today to need or want as much net money in retirement as they had when they were working, so they can maintain their standards of living. Since most retirees lose their largest tax deductions in retirement, they can often reach higher marginal brackets more quickly than they might have anticipated when they were still working and taking much larger deductions.

In addition to being conditioned to postpone the taxes on their retirement savings, few Americans look down the road at the implications of the required minimum distribution (RMD) rules when they reach age 70½. The RMD rules are such that anyone who has been successful in accumulating a large amount of money in their various tax-deferred retirement accounts may be surprised to find themselves in a higher-than-anticipated tax bracket in retirement. The ONLY retirement account that does not have required minimum distributions is the Roth IRA.

One solution to these concerns about taxes in retirement, or the prospect of higher taxes in the future, is the deliberate conversion of tax-deferred account holdings to tax-free Roth status and to take advantage of these historically low rates now and for the next seven years, hopefully until the new law sunsets on December 31, 2025.

The idea of emptying the same tax-deferred bucket that you just spent the last 25 to 35 years or more filling up may seem a little counterintuitive or uncomfortable, but the tax laws, RMD rules, and provisional income rules regarding Social Security taxation are what we all have to deal with. Large distributions from the tax-deferred bucket can influence and affect all of those items negatively unless and until you get the tax-deferred bucket down to zero over the next several years. This is because, for most people, the standard deduction of $12,000 (for single filers) or $24,000 (for married couples filing jointly) will be the only tax break they have, and amounts that exceed the provisional income thresholds will cause up to 85% of their Social Security to be taxed in perpetuity. Note that individuals who receive pension income will also likely have their Social Security taxed, and thus this type of planning is essential for these individuals as well.

The Mechanics and Implications 

While the Roth conversion process is quite simple, the implications at tax time each year should be understood beforehand. All the IRA custodian is really doing is recharacterizing that amount of money as a Roth holding now, and they will issue a 1099 form at the end of January that reflects the amount converted. This amount will be considered ordinary income by the IRS and will be added to your taxable income for the year that you make the conversion. If your goal is to convert all of your deferred holdings to Roth status in order to avoid the deadlines, taxes, and strict rules and penalties associated with RMDs and potentially eliminate or reduce the taxes on your Social Security in retirement, it will likely take you several years.

No income limits apply to Roth conversions. You can convert any amount of money at any time, with no penalties, even if you are under age 59½. The only caveat is that all converted dollars will be considered taxable income for you that year, so you should do some tax projections with your accountant BEFORE doing any conversions so that you know what the approximate impact will be the following spring.

Fiscal experts, such as David Walker, the former Comptroller General of the U.S. for 10 years and a man many have called the nation’s CPA, and Dr. Laurence Kotlikoff, a former chief economist for Ronald Reagan and an acknowledged expert on Social Security, continue to issue warningsabout the need for higher taxes in the not-too-distant future. As these and other prominent analysts and experts have explained, the simple math related to the country’s record debt levels and other obligations dictates higher taxes in the future, unless the political class somehow finds a way to make large, permanent, and politically painful spending cuts. At this stage, borrowing more money or simply printing more money are rightly regarded as dangerous paths to go down, so tax increases are highly likely. Kicking the fiscal responsibility can down the road can only go on for so long in any country.

In summary, converting IRAs and other qualified tax-deferred accounts to Roth status can yield great benefits for the owner and their heirs. When you convert money from an IRA or other tax-deferred account, you are essentially taking a pool of money from the “forever-taxed world” to the “never-taxed world” and insulating all those funds from any future tax increases that may come down the road, for you and your beneficiaries. Today’s generous brackets and low tax rates under the new law make converting funds to Roth status an intelligent and compelling retirement and legacy planning strategy.