A Roth conversion is relatively simple. In essence, you agree to withdraw funds from your IRA today, pay the associated taxes, deposit those assets into your Roth IRA, and enjoy tax free growth and withdrawals going forward. There are, of course, numerous rules that complicate things a bit, but most people conceptually understand the process.
Before we can get to the execution phase of converting the assets, we have to be sure the strategy makes sense given our individual circumstances. Much has been written to suggest that a Roth Conversion is most palatable when you assume (or know) that your tax rates in the future (at the time of distribution) will be higher than they are today. There are a number of cases where this may be true, but here are a couple of less traditional scenarios:
With the unemployment hovering at about 9%, many Americans find themselves with far less income today than they’ve had in previous years or than they would expect to have in future years. If you find yourself laid off, or out of work for any extended period of time, you may fall within a lower than typical tax bracket. A rough outline of your 2011 tax return could yield opportunities to convert assets that would “fill” the 10% or 15% tax bracket in 2011 with Roth conversions. Essentially, if your taxable income (adjusted gross income, or AGI, less deductions and exemptions) is on pace to fall below $34,500 for an individual, or $69,000 for a married couple, there could be an opportunity to convert at lower tax rates than you will have later in life.
We often engage retired clients in the Roth conversion discussion. There are a number of reasons why retired clients’ tax rates could rise- the introduction of social security, required IRA distributions at age 70.5, the onset of pension plan benefits down the road, or a change in fiscal policy to name a few. But the more subtle justification is one that I have read little about, which deals with the survivorship issues for married clients.
When a married couple enjoys retired life together they are typically subject to tax rules based on both spouses sharing a return. When the first spouse dies those rules change, and the amount of income allowed in each tax bracket is cut in half! The problem lies in the reality that income often doesn’t dramatically change. While the surviving spouse loses the smaller of the two Social Security checks, they retain the larger. Pension income will likely change, but many clients will choose survivor options for their pensions that leave up to 50% of the deceased spouse’s benefit on the living spouse’s return. If the couple had dual pensions, the surviving spouse may actually see an increase in their own pension, given they no longer have to pay for their own survivor benefit. And, finally, IRA income may not change much at all, especially if the couple is already subjected to required minimum distributions (RMDs). The surviving spouse will simply inherit the IRA balance of the deceased spouse, roll it into their own IRA, and have their personal RMD calculation applied to the combined balance.
We try to identify this planning opportunity long before it exists. We do tax planning each year for all of our retired couples to see if we have room in the lower tax brackets to complete Roth conversions. We have found that the optimum time to execute this strategy is early in retirement, leading up to the point when RMDs begin. For example, we may be able to convert a fair amount of assets in the years before Social Security begins, and complete smaller conversions in a couples’ late 60’s leading up to RMDs.
You could extend this same logic for couples that are willing to pay taxes at their rates today in order to provide Roth IRAs for their heirs, who presumably will have higher tax rates in the future. But we will leave that conversation for another day!
The truth is there are few rules of thumb in financial planning. If you think Roth conversions might fit within your tax planning, be sure to understand all of the nuances, both for Roth conversions themselves and for the general tax rules of various income types (specifically Social Security). Or better yet, seek advice from a financial planner or tax professional. Taking advantage of these opportunities when they exist can make a big difference in your life, your spouse’s life, or the life of your heirs in the future.
Mike Branham, CFP®
Cornerstone Wealth Advisors, Inc