The time is ripe to convert traditional, pretax retirement accounts to Roth-style accounts.
Low individual tax rates by historical standards and a pending reversion in 2026 to the higher rates that preceded the new tax law make this an opportune time, according to financial advisers.
There may be an additional incentive if the stretch IRA, a popular estate-planning vehicle, were to disappear courtesy of retirement legislation being weighed in Congress. Beneficiaries would have to take distributions from inherited individual retirement accounts in a compressed time frame, increasing the likelihood that withdrawals from traditional IRAs bump heirs into higher tax brackets — thereby making tax-free Roth distributions a valuable prospect.
"For many people, I think Roth is going to be better," said Leon LaBrecque, chief growth officer at Sequoia Financial Group. "I'm keen on it."
Financial advisers interested in doing Roth conversions with clients have a few strategies at their disposal.
Backdoor Roth IRA
Roth IRAs have income limits — in 2019, single people can't contribute to a Roth IRA if their modified adjusted gross income exceeds $137,000. But high-income clients can still get money into a Roth IRA via a so-called backdoor Roth IRA.
This strategy entails a two-step process: contributing money to a non-deductible IRA and then converting the account to a Roth IRA. This strategy wasn't possible prior to 2010 because of income limits on Roth conversions of traditional IRAs.
There are a few caveats. An individual with multiple IRAs is subject to an IRA aggregation rule, which takes all IRA assets — including pretax IRAs — into account when determining a conversion's associated tax. Advisers can sidestep the problem by rolling pretax IRA money into a 401(k) plan, which isn't subject to the aggregation rule.
Further, under something called the "step transaction doctrine," if the two steps of a conversion are completed within too short a time frame, the Internal Revenue Service may determine that they were really part of one transaction, said Michael Kitces, partner and director of wealth management at Pinnacle Advisory Group.
In that case, the IRS would treat the transaction like a Roth IRA contribution made by a high-income individual — a breach of tax rules. Mr. Kitces typically waits a full year between the contribution and conversion to avoid this.
Mega backdoor Roth
This strategy is similar to the backdoor Roth, but done within a 401(k) plan. The strategy entails making an after-tax 401(k) contribution and then doing an in-plan conversion to a Roth account using the after-tax money.
The higher 401(k) contribution limits allow clients to deal with larger sums of money. Individuals over age 50 can make $62,000 in total contributions to 401(k) plans in 2019 — including employee and employer contributions and after-tax contributions. A client who's over 50 potentiallycould make $37,000 in after-tax contributions annually, assuming there's no employer match.
"That's a huge amount of money," Mr. LaBrecque said.
A few caveats: Business-owner clients need to ensure the strategy wouldn't cause their 401(k) plan to fail non-discrimination testing. The 401(k) plan must also allow for after-tax contributions. Clients must max out their pretax and Roth contributions before making after-tax contributions.
Advisers often view a sell-off in the stock market as an optimal time to do a Roth conversion — account values are reduced, so the associated tax isn't as high.
In the past, clients could undo — or "recharacterize" — a Roth conversion if they didn't like the outcome. Clients would likely keep a conversion if the market went up afterward, and would undo it if markets fell, Mr. Kitces said.
The 2017 tax law changed that, making it imperative that advisers get it right the first time. Conversion-cost averaging is a timing strategy similar to dollar-cost averaging. If a client wants to convert $120,000 to a Roth account during the year, advisers can consider doing $30,000 a quarter or $10,000 a month, for example, rather than converting the whole thing at once, Mr. Kitces said.
This is another timing technique. Advisers will often try to "fill up" marginal tax brackets via Roth conversions. For example, if a client is $10,000 shy of being subject to a higher tax bracket, an adviser may choose to do a Roth conversion for precisely $10,000, thereby avoiding that higher rate.
This precision is difficult early in the year when advisers don't have a clear sense of clients' income and expenses. As a workaround, advisers can choose to "barbell" conversions, Mr. Kitces said, by converting a chunk of money at the beginning of the year and potentially "truing up" the conversions toward year-end. For example, if a client wants to convert a total of $100,000 during the year, perhaps do $80,000 in January and $20,000 in December, he said.
Advisers can even combine the conversion-cost averaging and barbell strategies by using the former in the first half of the year and the latter in the second half of the year, Mr. Kitces said.