Year-End Roth Conversion Planning

 

By Robert S. Keebler, CPA, MST, AEP (Distinguished)

Roth IRA conversions are an important part of bracket management and can be used to avoid the 3.8% net investment income tax (NIIT) and the higher income tax brackets. While some of the benefits of Roth IRA conversions may require a longer period of time to produce, these conversions are still an important strategy to consider at year-end.

Advantages of a Roth IRA
Roth IRAs have a number of advantages over traditional IRAs:

  • Lower overall taxable income long-term;
  • Tax-free, rather than tax-deferred growth;
  • No required minimum distributions (RMDs) at age 70½;
  • Tax-free withdrawals for beneficiaries after the death of the owner;
  • More effective funding of the bypass trust; and
  • Facilitates 3.8% NIIT planning and income smoothing.

Whether a Roth conversion will be favorable for a particular taxpayer, however, depends on the facts of the case. A detailed quantitative analysis is necessary to determine whether it provides an overall economic benefit in a particular case. This analysis begins with a comparison of the taxpayer’s marginal income tax rate at the time of the conversion and the taxpayer’s expected marginal income tax rate when distributions are received. If the tax rate at the time of the conversion is lower, the taxpayer will achieve a better economic result by converting. If the tax rate at the time of conversion is expected to be far higher than when distributions are received, the taxpayer will generally be better off not converting. If the tax rate at the time of conversion is expected to be slightly to moderately higher than at the time of distribution, a Roth IRA conversion might still be advisable because of special factors that favor a Roth IRA.

There are many factors that might favor a Roth IRA conversion:

  • The taxpayer has available funds outside of the IRA that can be used to pay the conversion tax. This, in effect, packs more value into the IRA.
  • The taxpayer has special favorable tax attributes, including charitable deduction carry-forwards, investment tax credits, net operating losses, high basis nondeductible traditional IRA, etc., that may help offset the taxable conversion amount.
  • Suspension of the minimum distribution rules at age 70½ provides a considerable advantage to the Roth IRA holder if the holder doesn’t need the payments for support and can accumulate them for transfer to their heirs.
  • Taxpayers benefit from paying income tax before estate tax (when a Roth IRA election is made) compared to the income tax deduction obtained when a traditional IRA is subject to estate tax.
  • Wealthy taxpayers making the Roth IRA election during their lifetime reduce their overall estate and estate tax payable.
  • Roth IRA distributions won’t cause an increase in tax rates for the surviving spouse when one spouse is deceased because the distributions are tax-free.
  • Post-death distributions to beneficiaries are tax-free.
  • Tax rates are expected to increase in the near future.
  • The new 3.8% NIIT – Roth IRA distributions are not included in net investment income or MAGI.

Avoiding the 3.8% NIIT
The 3.8% NIIT created an additional reason for doing a Roth IRA conversion—income smoothing.  Recall that the amount of net investment income subject to the 3.8% NIIT is the lesser of:

  1. Net Investment Income (NII), or
  2. The excess of MAGI over the applicable threshold amount (ATA).

Distributions from a traditional IRA are not considered NII, but they do increase MAGI. Thus, they could create or increase a taxpayer’s NIIT. By contrast, a Roth IRA distribution is neither NII nor MAGI, so it does not create or increase a taxpayer’s NIIT.  Therefore, a taxpayer can use a Roth IRA conversion to keep future income out of higher brackets and eliminate all future NIIT on IRA distributions.

 

Example 1. Taxpayer and spouse, married filing jointly, have salary income of $150,000 and dividend income of $100,000. They are not subject to the NIIT despite having $100,000 of NII because their MAGI does not exceed the ATA ($250,000-$250,000). If later, they also receive a $75,000 RMD from a traditional IRA, then the NIIT will apply to the lesser of NII ($100,000) or the excess of MAGI over ATA ($325,000-$250,000). Thus, the traditional IRA distribution will subject them to NIIT on $75,000 of income, resulting in NIIT of $2,850. If instead, the traditional IRA had previously been converted to a Roth IRA and they received a distribution of $75,000, they would not be subject to any NIIT; their MAGI would not exceed the ATA because a distribution from a Roth IRA does not count towards MAGI ($250,000-$250,000). The conversion would save them $2,850 in NIIT.

Roth IRA Conversions and Income Smoothing
If a taxpayer’s income is currently lower than it is expected to be in later years, the taxpayer might want to do a Roth conversion to “smooth out” income. The reason why Roth IRA conversions are an important strategy to consider at year-end is because the conversion can be done in stages so that the tax payable on the conversion does not push the taxpayer into a higher tax bracket, increase MAGI and/or NIIT in the year of conversion.  Taxpayers can limit annual conversions to the amount that fills up their current marginal tax bracket.  It should be noted, however, that there may be times when it does make sense to convert more and go into the higher tax brackets.

 

Example 2. Taxpayer (T), filing single, has MAGI of $37,850, giving T a marginal tax rate of 25%. T wishes to convert his traditional IRA into a Roth IRA because T expects his marginal tax rate to increase in the future. T owns a traditional IRA worth $200,000. Instead of converting the entire IRA, T converts only $50,000. This increases T’s MAGI to $87,850, the top end of the 25% marginal tax bracket. Thus, the conversion does not increase T’s marginal tax rate.

Re-characterizing a Roth IRA Conversion
The ability to re-characterize a Roth IRA back to a traditional IRA if the assets drop in value eliminates much of the risk of Roth conversions. Taxpayers may “re-characterize” (i.e., undo) the Roth IRA conversion in the current year or by the filing date of the current year’s tax return. Thus, re-characterization can take place as late as October 15th of the year following the year of conversion.

 

A taxpayer would re-characterize if the Roth IRA dropped in value between the date of conversion and the deadline for re-characterizing. However, a taxpayer cannot re-characterize only a portion of a Roth IRA conversion by “cherry picking” only those stocks that decline in value. All gains and losses to the entire Roth IRA, regardless of the actual stock or fund re-characterized, must be pro-rated. Therefore, it might make sense to set up separate Roth IRAs for each asset class invested in; thereby allowing the taxpayer to re-characterize only those Roth IRAs whose asset class declined in value.

Example 3. T owns a traditional IRA with $100,000 of Asset A and $100,000 of Asset B. On 12/31/2013, T converts that IRA to a Roth IRA. Assume that by October of the next year the value of Asset A has increased to $120,000 and the value of Asset B has declined to $90,000. T would like to re-characterize Asset B but not Asset A. However, the applicable regulations do not allow T to re-characterize specific assets. T can only re-characterize a specific dollar amount of the entire IRA.

Example 4. Assume the same facts as in Example 3 except that T converts the traditional IRA into two Roth IRAs, Roth IRA 1 holding Asset A and Roth IRA 2 holding Asset B. T can now re-characterize only Roth IRA 2, keeping the benefit of the appreciation in Asset A without the loss in Asset B.

Finally, if you change your mind again, assets you re-characterized to a traditional IRA can be reconverted to a Roth IRA. The reconversion must be done by the later of (1) the year after the conversion or (2) 30 days after the re-characterization.

Conclusion
If a taxpayer expects his marginal tax rate to increase in the future a Roth IRA conversion can provide long-term benefits – keeping the taxpayer out of the higher tax brackets and lowering their MAGI, thereby avoiding the NIIT.  Furthermore, these long-term benefits can provide even more economic benefit if Roth IRA conversions become a part of year-end tax planning – doing the conversion in stages to fill up the taxpayer’s current marginal tax rate bucket instead of doing it all at once and possibly subjecting the taxpayer to a higher marginal tax rate or the NIIT. Therefore, an analysis of the client’s specific situation is necessary at the end of each year to determine if Roth IRA conversions will provide them any economic benefit.

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ABOUT THE AUTHOR
Robert-Keebler1744 (6)Robert S. Keebler is a partner with Keebler & Associates, LLP. He has received the prestigious Accredited Estate Planners (Distinguished) award from the National Association of Estate Planning Counsels and has been named by CPA Magazine as one of the Top 100 Most Influential Practitioners in the United States.  Mr. Keebler is the past Editor-in-Chief of CCH’s magazine, Journal of Retirement Planning, and a member of CCH’s Financial and Estate Planning Advisory Board. Mr. Keebler frequently represents clients before the National Office of the Internal Revenue Service (IRS) in the private letter ruling process and has received over 150 favorable private letter rulings. Mr. Keebler is nationally recognized as an expert in family wealth transfer and preservation planning, charitable giving, retirement distribution planning and estate administration and works collaboratively with other professionals on academic reviews and papers, as well as client matters.  He can be reached at (920)593-1701 or at [email protected].

 

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