Roth conversions can add a lot of value to a retirement income plan. Advisers can control when Roth conversions take place, and therefore can be strategic and do conversions in years when tax rates for a particular client might be lower than in retirement.
We can also spread out conversions over time to prevent pushing into new tax brackets — all while still managing to move the money from an IRA, where it's subject to RMDs while the owner is alive, to a Roth IRA, where it's not subject to RMDs while the owner is alive. Roth conversions are valuable from a tax planning, estate and control perspective.
However, Roth conversions don't come without complexity and pitfalls. Here are three areas of Roth conversions I see advisers often stumble into along with planning tips to consider.
1. The 10% penalty trap
When you convert tax deferred money in an IRA to a Roth IRA, you pay ordinary income taxes on the converted amount but not the 10% early distribution penalty tax. But, if you take money out of the IRA to pay for the conversion, you could trigger a 10% penalty on that portion of the money if the owner of the IRA is under age 59.5 and no other applicable exception to the penalty applies.
Planning tip: Pay money for taxes owed at a conversion from outside of the IRA. This helps you avoid the 10% penalty issue and allows you to essentially convert more tax-advantaged money into the Roth IRA.
2. Backdoor Roth conversions
A huge issue that comes up from time to time when doing a Roth conversion is not aggregating all IRAs together. This often happens when someone's income exceeds the limit for Roth contributions and tries to engage in a backdoor Roth transaction.
Instead of contributing directly to a Roth IRA, they contribute a nondeductible amount to an IRA and convert it over to a Roth IRA. If the nondeductible contribution is the only money in the IRA, no taxes will be due at conversion, thereby getting around the Roth IRA contribution limits. However, if other outstanding IRAs existed, including SEP and SIMPLE IRAs (which are really the accounts people forget about), the person would need to aggregate all the accounts together for purpose of a conversion.
Let's take a look at an example. Imagine you have a $495,000 SEP IRA and put $5,000 into an IRA as nondeductible as a backdoor Roth conversion of $5,000. You need to aggregate together all the IRAs, which means your nondeductible is only 1% ($5,000/$500,000) of the existing total IRA amounts. Only 1% of your conversion will be tax free. The other $495,000 will be subject to ordinary income taxes.
Planning tip: If you want to engage in the backdoor Roth IRA strategy but have existing outstanding IRA money, consider rolling it back to a company 401(k) plan if possible. Or, just make sure you understand you'll pay taxes on the conversion until all of your taxable portion is converted or withdrawn from the IRA.
[Recommended video: How to help clients make it through retirement]
3. Can't convert RMDs
Many advisers are aware that you can't convert or roll over a required minimum distribution. Timing still plays a role, though. You can do Roth conversions after age 70½, but you need to be careful not to convert an RMD.
In the year you reach age 70½, the first distributions you make from an account subject to RMDs are treated as RMDs. Let's say your client is 71 years old. They want to spread out the RMDs throughout the year — the total is $24,000, so over 12 months it'd be $2,000 a month.
That's all fine and dandy. But now let's say halfway through the year the client decides it's a good year to do a Roth conversion of $10,000. If only $12,000 of the $24,000 RMD has been taken out at that point, the $10,000 conversion will be treated as an improper rollover and contribution to a Roth IRA. To fix this would require pulling the money and all gains out, or doing a recharacterization of an excess contribution. However, this highlights the point that timing is important.
Planning tip: You can do Roth conversions after age 70½, but make sure all RMDs are taken before any Roth conversions occur. Know how much your clients have withdrawn before discussing a Roth conversion, because any converted amounts will be in addition to all other RMDs, perhaps causing the client's tax bill to rise.
Roth conversion strategies can add a lot of value to a retirement income plan, but advisers need to know the rules so not to cause extra headaches or tax burdens for their clients.
[More: Funding an HSA with an IRA]
Jamie Hopkins is director of retirement research and vice president of private client services at Carson Group.