Strategic Wealth Partners was acquired by Kovitz Investment Group Partners, LLC ("Kovitz"), a registered investment adviser with the SEC on May 1, 2024. Strategic Wealth Partners is now a division of Kovitz and its registered investment adviser. Materials created prior to this date were created by Strategic Wealth Partners and are accurate as of the time of publishing.

Taking a Closer Look at Roth Conversions

Roth conversions are a popular planning concept that we at SWP discuss and implement with clients on a regular basis.  What is it?  Why do clients do it?  And why might a client not do it? Before we begin, please note that the content below is meant for informational purposes only and should not be treated as tax advice.  Always consult with your tax advisor before implementing any Roth conversions.

Some Background For Context:

Generally speaking, retirement savings accounts, like your 401(k) or traditional IRA, are funded with pre-tax dollars, which benefit from tax-free growth but are then subject to income taxes when withdrawals are made.  Pre-tax retirement accounts are further subject to Required Minimum Distributions (RMDs) once the account owner reaches age 73 (increasing to age 75 starting in 2033). 

On the flip side, Roth IRAs are retirement accounts that are funded with after-tax dollars.  The growth in Roth accounts is tax-free, withdrawals are tax-free (subject to the 5-Year Rule and being over the age of 59 ½), and there are no RMDs.  For more information on the 5-Year Rule surrounding tax-free withdrawals, reach out to your wealth manager or tax preparer.

What Is A Roth Conversion?

A Roth conversion is when you move dollars from a pre-tax retirement account to an after-tax Roth IRA.  In doing so, a taxable event occurs, and you will owe income taxes on the amount converted.  For example, if you convert $50,000 from your Traditional IRA to your Roth IRA, you will include $50,000 as ordinary income on your tax return.

So, while retirement accounts are typically considered as assets on a balance sheet, put another way (and in the eyes of the IRS), they are actually income that has not yet been taxed.  And while there are limits on Roth contributions, since 2010, there are no limits on Roth conversions.

Why Do Clients Consider Roth Conversions?

In my experience, clients are typically not excited to pay more in taxes if they do not have to.  With Roth conversions, however, clients are generally more comfortable with the concept of paying some taxes now to assumingly avoid paying more in taxes later.  As mentioned above, in the eyes of the IRS, traditional retirement accounts are just income that has not been taxed, and that tax bill is expected to grow in size over time as the account value (assumingly) increases. 

Knowing that, here are a couple of reasons why considering Roth conversions may make sense for you:

1. You Believe Tax Rates are Going Up or You Will Be in a Higher Tax Bracket Later

By historical standards, today’s federal income tax rates are relatively low, and we do know that under the current law, they are set to go up starting in 2026 with the sunset of the Tax Cuts and Jobs Act (TCJA) of 2017.  With that in mind, individuals may want to consider conversions now, locking in lower rates in the hopes of averting higher tax rates later on.

Coupled with this, if you currently live in a state that does not tax retirement account distributions but you plan to move to a different state in retirement that taxes RMDs, you may further consider Roth conversions.  Check out websites like SmartAsset.com for more information on how your state taxes retirement income.

2. Reduce Future RMDs

Even if tax rates do not go up, the amount of taxable income you will have to take as a result of future RMDs will likely go up, assuming your retirement account value continues to grow.  Regardless of whether you need the income, you will have to take RMDs whether you like it or not, potentially pushing you into higher future tax brackets.  Making Roth conversions will help incrementally reduce future RMDs that would result.

3. To Take Advantage of Market Declines

During times of market volatility, those who could afford to make Roth conversions, have the opportunity to potentially convert more shares per dollar.  For example, the S&P 500 was down about 18% in 2022.  Let’s assume at the start of the year, you were contemplating a Roth conversion, and had 1,000 shares in an S&P 500 ETF at $100/share for $100,000.  By year-end, those same 1,000 shares were at $82/share and could be converted for $82,000, presenting an opportunity to convert the same amount of shares to a Roth for $18,000 less in taxable income.

4. Legacy Planning

Another common reason we see Roth conversions is that Roth IRAs are a great asset to leave to heirs. Roth IRAs left to your heirs are an income tax-free asset.  And with the recent SECURE Act’s elimination of the stretch IRA, they will have up to 10 years following your passing in which to withdraw from the inherited Roth account, allowing for additional compounding tax-free growth.   

For clients who leave a pre-tax retirement account to their heirs, those who inherit the account will have to pay income taxes on the withdrawals they take.  And as mentioned above, they will have 10 years in which to make those withdrawals under the SECURE Act.  With a Roth conversion, though, by paying the taxes now, your heirs will not have to pay any income taxes on the account in the future when they inherit it .  Additionally, once someone inherits a pre-tax IRA, they cannot make Roth conversions on that account.

5. Tax Diversification

Similar to the idea of diversifying your portfolio assets, by creating and building up Roth accounts through conversions, you can help enhance your “tax diversification” come retirement.  With a mix of Roth, traditional IRAs, and brokerage accounts, you can be more flexible when it comes to withdrawal strategies to help minimize your tax liability in retirement.

Why Should You Not Do a Roth Conversion?

Roth conversions are complex and not necessarily for everyone.  Before you consider conversions, you should confirm with your wealth manager and tax preparer that they make sense with all of the other variables at play to meet your financial goals and priorities:

1. You Cannot Undo

Prior to the Tax Cuts and Jobs Act (TCJA) of 2017, you used to have the ability to undo a Roth conversion, but now they are irrevocable.

2. You Could Trigger More Taxes, Beyond Ordinary Income

Depending on how much you do in Roth conversions, you could push up your income to a point where you become subject to some “gotcha taxes” like the Net Investment Income Tax (NIIT) or the income-related monthly adjusted amount (IRMAA) surcharge added to your Medicare Part B and D premiums 2 years down the road.

Roth conversions could result in more of your Social Security Retirement benefits being taxable and may even require you to make estimated tax payments before you have to file your annual return.

3. Lack of Cash Flow or Assets to Pay the Tax Bill

When doing a Roth conversion, you want to make sure you have sufficient cash on hand to pay the tax bill.  For some clients, they may not have enough cash or savings in which to cover the additional tax bill.  

4. Time to Recover

When you make a Roth conversion, you are out the money to pay the taxes that you otherwise could have reinvested elsewhere.  Depending on your balance sheet, cash flow, and growth rate assumptions, it could potentially take years to recoup from the net impact of doing the conversion and paying the taxes vs. not doing the conversion.

5. Charitably Inclined

For clients who are charitably inclined, going through with a Roth conversion might not make too much sense either.  By using Qualified Charitable Distributions and leaving an IRA outright to charity after your passing, realizing income by converting pre-tax balances to a Roth may not be in your best interest.

Roth conversions are complex and are not for everyone.  Please reach out to your advisor at SWP to discuss whether Roth conversions make sense for you and your financial plan.

 
The information herein was obtained from third party resources that Strategic Wealth Partners (“SWP”) deems to be reliable as of the original date of publication. SWP does not provide legal or tax services. The information provided is for general informational purposes only.

 


Disclosure:

    This article contains general information that is not suitable for everyone. The information contained herein should not be constructed as personalized investment advice. Reading or utilizing this information does not create an advisory relationship. An advisory relationship can be established only after the following two events have been completed (1) our thorough review with you of all the relevant facts pertaining to a potential engagement; and (2) the execution of a Client Advisory Agreement. There is no guarantee that the views and opinions expressed in this article will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

      Strategic Wealth Partners (‘SWP’) is an SEC registered investment advisor with its principal place of business in the State of Illinois. The brochure is limited to the dissemination of general information pertaining to its investment advisory services, views on the market, and investment philosophy. Any subsequent, direct communication by SWP with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of SWP, please contact SWP or refer to the Investment Advisor Public Disclosure website (http://www.adviserinfo.sec.gov).

      For additional information about SWP, including fees and services, send for our disclosure brochure as set forth on Form ADV from SWP using the contact information herein. Please read the disclosure brochure carefully before you invest or send money (http://www.stratwealth.com/legal).

      Financial Planning
      The Power of Consolidating Your Investment Accounts
      The modern financial landscape is complex and constantly evolving.  However, managing complexity and delivering simplicity can come from consolidating these elements under the stewardship of a knowledgeable professional. A professional...
      Read More