By Gary K. Liska, MS, CFP®, AIF, CRPC, AAMS
Founding Partner, CFO
Here’s what you need to know
At a time when both income and estate tax rates are at or near historic lows, the federal government has pumped an unprecedented $5+ trillion of stimulus into the economy to help offset the impact of COVID-19. Those two facts—considered in tandem—make it hard to imagine that tax rates won’t be somewhat (and perhaps considerably) higher when you eventually make the transition into retirement.
One way to gain some flexibility in adapting to unknown future tax rates is by ensuring you have a well-balanced mix of retirement savings in taxable (brokerage), tax-deferred (401k and traditional IRA), and tax-free (Roth IRA) accounts. This way, depending on your individual financial circumstances as well as the tax environment, you’ll be able to tap into your various accounts to generate income in a way that can benefit you most.
Why a Roth?
Although contributions to a Roth IRA aren’t tax deductible, any qualified distributions you take from them in retirement are tax-free. And unlike traditional IRAs, there’s no mandate to take Required Minimum Distributions (RMDs) from your Roth beginning at age 72—so if you don’t need the income, you can leave the account to grow.
There are income limits for contributing to a Roth—but these limits don’t apply to Roth conversions. Anyone with a traditional IRA can convert it to a Roth. But to do so, you’ll be required to pay income taxes on some or all of the amount you convert; so you need to have cash on hand. Assuming you can pay the income taxes due, a conversion may make sense if either of the following apply:
- You expect higher taxes in retirement: by converting to a Roth you’ll be paying taxes on your savings now rather than when you take distributions. This will benefit you if your current tax rate is lower than what rates will be in the future.
- You intend the assets to go to your beneficiaries. Because you don’t need to take RMDs from your Roth (and any distributions are tax-free), they can be an effective vehicle for wealth transfer.
Making an informed decision
There’s both a qualitative and a quantitative aspect to deciding whether or not a Roth conversion makes sense based on your circumstances and needs. You, your tax advisor and your financial advisor will want to work together to assess your expected income needs (how much you’ll need to draw-down each year, when you’ll begin taking distributions, and how long you expect to live).
You’ll want to calculate your effective income tax rate for the year of conversion as well as an estimated marginal rate during retirement. And then you will need to determine how much to convert and where the funds for paying conversion taxes will come from (remember you don’t want to pay the taxes using retirement funds). Lastly, consider creating different ‘what if’ scenarios by adjusting variables. What if tax rates go up? What if I die sooner than expected? This should help in making your decision.
New distribution rules for inherited IRAs
As part of the 2020 SECURE Act (Setting Every Community Up for Retirement Enhancement), new distribution rules were put in place for inherited IRAs. Rather than being able to ‘stretch’ distributions out over the beneficiary’s life expectancy, most non-spouses who inherit IRA assets are now required to fully distribute all the account assets within 10 years of the original owner’s death.
This condensed distribution period could be problematic for your heirs—creating excess tax liability or even lifting them into a higher tax bracket. A Roth conversion may help solve this dilemma since inherited Roth assets are tax-free and therefore require no mandatory distributions.
A complex decision
If you experience an unexpected income disruption this year, you might find yourself temporarily in a lower tax bracket. Assuming you have enough cash on hand to pay the tax bill, this could provide you with an opportunity to convert a portion of your traditional IRA assets into a Roth IRA at a lower tax rate.
That’s just one scenario among many which can drive a Roth conversion decision—critical but complex decisions where making the right choice requires not only knowledge of the features, benefits, and limitations of each account type, but also an in-depth understanding of your financial life, needs, and goals. So if you want to be confident that a conversion makes sense for your overall wealth plan, make sure you involve both your financial and tax advisors.
Gary K. Liska may be reached at 310 712-2323 or www.seia.com
 “How the $1.9 trillion U.S. stimulus package compares,” Washington Post, March 10, 2021
Securities offered through Royal Alliance Associates, Inc. member FINRA/SIPC. Investment advisory services offered through SEIA, LLC, 2121 Avenue of the Stars, Suite 1600, Los Angeles, CA 90067, (310) 712-2323. Royal Alliance Associates, Inc. is separately owned and other entities and/or marketing names, products or services referenced here are independent of Royal Alliance Associates, Inc.