Tilt odds in clients’ favor to win year-end Roth conversion bet

Congress has retirement accounts in its sights for future tax increases, but financial advisers can help their clients make some defensive moves now.

As we’ve seen from recent tax proposals, Congress has retirement accounts in its sights for future tax increases, especially the larger IRAs. We know what the tax rules and tax rates are for 2021, but advisers can also help clients make some defensive moves now, just in case any of these IRA tax proposals resurface in future years.

THE ROTH CONVERSION BET

Roth conversions are particularly sensitive to potential higher tax rates because the conversion itself, is, in essence, a bet on future tax rates being higher than they are now. Financial and tax advisers are in the best position now to see which clients are in a better position to win that bet over the long haul.

YEAR-END ROTH CONVERSION TIMING

Conversions can be done at any time, but you might want to have certain clients accelerate conversions this year to take advantage of historically low current tax rates. Conversions could cost more down the road.

To qualify for a 2021 Roth conversion, the funds must leave the IRA or plan this year, in 2021. It’s OK if the funds don’t end up in the Roth until early next year, as long as they’re converted within 60 days. The better move, to make sure the funds are counted as 2021 conversions, is to do a direct rollover right from the IRA or plan to the Roth IRA.

NO DO-OVERS ON ROTH CONVERSIONS

Roth conversions are permanent — they cannot be undone. So now, near year-end, is the time to evaluate how much the tax cost will be. The client will need to have the funds available to pay that tax next year, or through estimates or withholding for this year, even if their financial situation changes. They need to know that for sure before they convert anything. It’s generally more tax-efficient to pay the tax with outside (non-IRA) funds.

Most clients, or their tax advisers, will have a good estimate of what their 2021 tax bracket and their marginal tax rate will be, since most of their income items will be known by now. Even if this year’s tax rate may seem high, let clients know that holding off on conversions could cost them more in future years, based on the handwriting on the wall from Congress.

The ideal Roth conversion planning strategy is to convert when tax rates will be the lowest, which for many may be 2021, compared to what future rates could be. If conversions are deferred, then the IRA continues to grow and the larger that balance, the higher the tax bill will likely be in future years.

Yes, the Roth conversion is a bet, but an educated one you can plan for. However, the larger the IRA balance grows, the greater the odds of winning that tax bet become, since larger IRA balances will mean higher future RMDs and related tax bills, not to mention the stealth-type taxes that result when income and potential future tax rates increase.

PRE-RMD CONVERSIONS

Identify clients who aren’t yet subject to required minimum distributions. For most clients, these will begin at age 72. Once RMDs begin, they cannot be converted, so it will cost more to convert at that point. The RMD amount must be satisfied first, and then any remaining balance can be converted.

For example, those in their 60s make good conversion candidates since they have a few years to start a plan to do perhaps smaller annual conversions, staying in lower brackets (or marginal rates) before RMDs begin.

PRE-IRMAA CONVERSIONS

Medicare income-related monthly adjustment amount charges, or IRMAAs, for Parts B and D are tricky to estimate, for two reasons.

One is that these charges don’t appear on tax returns as a tax. They are charged and paid separately, so often they’re not considered when reviewing a tax return to project future tax costs.

Second, IRMAA charges have a two-year look-back provision, so a Roth conversion done this year won’t trigger those charges until 2023.

Large Roth conversions can be one of the big income items that can cause increases in IRMAA charge. Those increases work on a “cliff” basis, meaning that going just $1 over the income limit can push you into the next bracket, increasing IRMAA charges by hundreds of dollars. What to do now? Advise clients ages 62 and younger to consider Roth conversions. Once they reach age 63, given the two-year look-back provision, IRMAA charges will likely be affected, making the conversion more expensive.

DEATH OF A SPOUSE IN 2021

It’s likely that every adviser reading this works with a married couple in which one spouse died this year. For the surviving spouse, look seriously at a Roth conversion this year. This may be the last year that spouse will be able to take advantage of lower married-filing joint tax return rates. Get the 2021 Roth conversions on the final joint tax return. Next year, the surviving spouse will likely be filing at much higher single tax rates, making future IRA distributions more costly.

Help your clients win the big Roth conversion tax bet by tilting the odds in their favor. Match these timely year-end Roth conversion strategies to your clients who can benefit most, both now and in future years.

[More: Court rules inherited 401(k) funds are protected in bankruptcy]

For more information on Ed Slott and Ed Slott’s 2-Day IRA Workshop, please visit www.IRAhelp.com

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