With the potential tax law changes impacting some popular Roth conversion strategies beginning in 2022, many people are asking whether they should go ahead and convert some of their IRA assets to Roth IRAs before the end of the year.
As in most things in personal finance, the answer is “it depends.” Here are eight questions to consider to help you make a well-informed decision:
- Are you in a higher tax bracket today than you likely will be in later years? A Roth conversion is really just a play on tax rates. If you think your tax rate will be higher in the future, it makes sense to convert and pay taxes now. If you think it will be lower in the future, then it probably is best to continue to defer income and therefore not convert to a Roth. And if you plan on retiring prior to age 65, then there may be some lower tax years before you begin collecting Social Security benefits, pensions and other income where you can utilize a Roth conversion or other planning strategy.
- Does any portion of your IRA accounts consist of after-tax contributions? If most of your IRA accounts are after-tax contributions, then the tax implications should be minimal. You’ll want to first understand how much of your IRAs are considered “basis,” which just means how much were after-tax vs. pre-tax contributions. The after-tax contributions are not taxable when converted to a Roth. All pre-tax contributions and earnings are taxable your marginal tax rate, which can be higher than your current tax bracket if you are collecting Social Security benefits and they were not all previously taxable.
- How will you pay for the additional tax liability after you convert? If you do not have the cash available and fail to withhold taxes, then you may be in for a surprise when you go to file your 2021 tax return. And if you’re under age 59.5, any amounts withheld to pay taxes on the conversion will be subject to a 10% penalty on early distributions.
- Will your beneficiaries likely be in a higher tax bracket than you are in now? If legacy planning is important to you, don’t forget about the recent tax law changes from the SECURE Act, which gives beneficiaries up to 10 years to distribute IRA assets instead of spreading it out over their expected lifetime. Depending on the number of beneficiaries and their own estimated income at that time, this could push them into a higher tax bracket than you are in now.
- Are your investments temporarily down? When life gives you lemons, make lemonade. Large stock market pullbacks can be a great time for a Roth conversion. It allows you to pay taxes on a lower value that will (hopefully) recover back to their previous levels and then continue to appreciate.
- What is the intent of your IRA? For some, they use it for their annual charitable gifting through qualified charitable distributions (QCDs) once they are over age 70.5 and/or have designated a charity or charities as the beneficiary. In these cases, it may not be beneficial to convert it to a Roth.
- Do you expect your estate will be subject to federal or state estate taxes? With the current federal estate tax exemption set to cut in half on January 1, 2026, if not sooner, the estate tax exemption will be likely around $6 million per person. With the top federal estate tax rate at 40%, one way to reduce your potential estate tax liability is to convert IRA assets to a Roth IRA, which effectively reduces your estate by using assets to pay taxes now on the conversion.
- Are you on the health care exchange, receiving the expanded child tax credit, on Medicare, or subject to any other potential loss of benefits or surtax based on your income? There are many other tax implications that should be factored in when determining the true cost of a Roth conversion.
It should also be pointed out that a Roth conversion is not an “all or nothing” decision. You can choose to convert only a portion of your IRA assets, which is usually the most common strategy as individuals attempt to fill up lower tax brackets when their income is temporarily down.
Still wondering whether it makes sense for your own situation? Feel free to reach out to us to see how we can help.
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