2019 will come to an end sooner than we might like, and unless you and your clients act quickly you may have lost another opportunity to save taxes over the long term by converting a portion of certain clients’ IRAs to Roth IRAs.
The cost of the conversion is immediate but, usually, relatively small when compared with the prospective benefits. Yet, there are a few things to think about before you and your clients make the move.
Why?
Clients are going to need a good reason to pay taxes today that they could otherwise delay. The primary motivation behind the conversion is that the amount converted will (hopefully) be taxed at a lower rate now than it would be in the future. That prospective higher future tax rate could come from a change in the tax laws that would raise taxpayers’ income tax rates. But a more likely effect is that the client’s income is higher in the future, especially due to currently deferred Social Security and pension payments. This high-tax scenario is especially scary for clients who have seven-figure sums in their IRAs, 403bs and 401(k)s, and will face mid-five-figure required minimum distributions (RMDs) at age 70 ½ (and beyond).
Paying a little in taxes now to save a lot later isn’t the only benefit of converting IRAs to Roth IRAs. Of course, there is no required mandatory distribution of Roth IRAs while the owner is alive. The future earnings on the account will still be sheltered from taxation, but any future distributions from the Roth IRA will be tax-free. Better yet, under today’s laws, Roth IRA distributions aren’t counted in the IRS formula used to determine if Social Security benefits are taxable income. So in theory a client could take a fortune from a Roth IRA while collecting Social Security and still pay little or no income taxes.
Another bonus of the conversion is that IRA owners who convert can allow their beneficiaries to inherit a prefunded Roth IRA. Yes, the beneficiaries will have to make RMDs on the inherited Roth IRAs, but the amount will be relatively small, and tax-free. In fact, it may behoove high-income prospective Roth IRA beneficiaries to pay the taxes on the conversion for the older IRA owners, especially if the tax rate on the conversion is lower now than what it would likely be if and when the heirs receive the IRA, and take the RMDs from that account.
When
Again, the best time to make the conversion is a year in which the tax rate on the conversion is likely to be lower than the rate at which future withdrawals would be taxed. Often that situation occurs right after a client retires but before she starts receiving Social Security (and any pension) payments. Ideally the client would have assets held outside of tax-sheltered accounts that can be tapped to cover living expenses, allowing all distributions from the IRA to be rolled into the Roth IRA.
Your clients who own homes should consider establishing a home equity line of credit (HELOC) for as much as the lender will allow. Then if the clients need funds above and beyond their unsheltered savings, they can pay a little bit of interest by tapping the HELOC, instead of a lot of taxes from withdrawing even more from the IRA.
Another way to drive down the clients’ taxable income is to donate any substantially appreciated stocks or other assets to a qualified charity or donor-advised fund, and then use the tax break to offset taxes on converted amounts.
How much?
For most middle-income (and moderate-spending) clients, the key figure to convert from IRAs to Roth IRAs in a given year is an amount that will still keep their taxable income below the top of the 12% federal income tax bracket. For 2019, that figure is $39,475 for a single filer and $78,950 for married couples filing jointly. Anything over those amounts is taxed at 22% by the feds until the figures rise to $84,200 and $168,400 respectively, when the rate inches up to 24%. Keep in mind that taxpayers over 70 ½ can’t convert their RMDs to Roth IRAs, but they can convert amounts over the RMD figure to Roth IRAs. Clients who don’t want to bother (or pay) their tax preparer to run some conversion amount scenarios can estimate the potential tax effect by using H&R Block’s Free Income Tax Calculator.
Beware of unintended consequences
Adding extra income to the clients’ 1040s could trigger some extra costs, beyond the taxes.
First, if the clients are receiving Social Security retirement benefits, the extra income could make the Social Security taxable, or make more of it taxable than it would be without the conversion. Also, the extra taxable income could drive long-term capital gains realized during 2019 from 0% taxation at the federal level up to 15% in a hurry. Clients who currently qualify for subsidized health insurance premiums under the Affordable Care Act may lose the subsidy if their income is too high. Or Medicare recipients could see an increase in premiums during future years from an excess of income taken this year. Even after these factors have been considered, you may want to wait to make any conversions until any mutual funds held in unsheltered accounts distribute all of their year-end dividends and capital gains.
The calculations require more precision than before. Unlike previous years, now clients can’t “recharacterize” (i.e., “undo”) conversions made in 2019 before the following April 15. Therefore, once the clock strikes midnight on Dec. 31, 2019, the amount converted is permanently counted as taxable income.
Considering how narrow the window of opportunity may be, you should start talking with clients now, and maybe get the paperwork signed in advance in case they decide to follow through with the conversion before Dec. 31.
