Help Your Clients Understand and Navigate Roth IRA Conversions

As a financial advisor, you help your clients make informed decisions to optimize their financial futures. And taxes are an important consideration. One tax strategy worth exploring is a traditional IRA to Roth conversion. This strategy can be advantageous under certain circumstances; however, it also brings its own set of challenges. Here’s what you need to know to guide your clients through these critical decisions, and why the fourth quarter is an optimal time to discuss it. 

While contributions to a Roth IRA are subject to income restrictions, Roth conversions are available to all investors, enabling people at any income level to take advantage of a Roth’s key benefit—tax-free qualified distributions. If your client anticipates being in a higher tax bracket when distributions are taken, by paying taxes now at a potentially lower rate, they avoid higher tax payments on withdrawals later. This can be particularly advantageous for covering occasional large expenses in retirement like home renovations/repairs or vacations without incurring additional tax liabilities.

Unlike traditional IRAs, Roth IRAs do not have required minimum distributions (RMDs) for the original owner allowing the assets to continue to grow tax-free, giving your clients more control over their retirement income streams.

Roth IRAs also offer estate planning benefits. Generally, Roth IRA beneficiaries can enjoy tax-free distributions, which can be especially attractive if the beneficiaries are likely to be in a higher tax bracket. Under the SECURE Act of 2019, non-spousal beneficiaries must withdraw all inherited Roth IRA funds within 10 years, helping to preserve more wealth across generations.

Despite the benefits, there are some potential drawbacks to Roth conversions. The most significant being the immediate tax liability. This increase in taxable income can lead to higher taxes on Social Security benefits and higher Medicare premiums. And for clients with children in college, higher taxable income could also affect eligibility for financial aid.

Navigating a Roth conversion requires careful planning and a strong understanding of your client’s financial situation. Your expertise can assist clients in a number of ways, including:

Tax analysis—You can conduct a thorough analysis of your client’s current and future tax rates to determine the most tax-efficient strategy for the conversion. As previously mentioned, the most significant drawback is that tax must be paid on the conversion amount, which can push your client into a higher tax bracket in the year of the conversion. A partial conversion can stagger conversions over multiple years to potentially avoid pushing your client into a higher tax bracket.

Funding strategy—You can help your clients explore various strategies for covering these taxes with minimal financial impact.

• Paying the taxes on the conversion from a taxable account is often the least disruptive approach from a tax perspective.
• For clients over age 59½ who have had their Roth IRAs for more than five years, taking tax-free withdrawals from existing Roth IRAs to pay for the taxes on the conversion is also an option.
• Although not ideal due to potential penalties and additional taxes, withdrawing funds from a Traditional IRA to cover taxes on the conversion is another possibility, especially if no other sources are available.

Coordination with retirement planning—You can integrate the Roth conversion strategy into your client’s overall retirement plan, including Social Security claiming strategies and the order of account drawdowns. As previously mentioned, taxable income from large conversions can increase the portion of Social Security benefits subject to tax and raise Medicare premiums.

Timing—Timing a Roth conversion depends on several key factors and each client’s individual circumstances. The following scenarios may make a Roth conversion advantageous for your clients:

• During years of lower income—If your client’s income for the year is lower, which could be due to a sabbatical, temporary unemployment, commission payout timing, or any other situation that causes a dip in annual income, it may make sense to consider a Roth conversion because the amount converted will be taxed at a lower rate.
• Before RMDs begin—Clients who are early in their retirement and not yet taking RMDs may benefit from a Roth conversion because it could reduce future RMD amounts, which can help manage future tax brackets and Medicare premiums. And with SECURE 2.0 pushing back the starting age for RMDs to age 73 (which will be extended to age 75 in 2033), retirees have additional time to implement a Roth conversion.
• When tax rates are anticipated to rise—When tax rates are expected to increase in the future, due to personal income growth, changes in tax laws, or expected increases in statutory tax rates, converting at current lower rates may be beneficial.
• When significant market growth is anticipated—Roth conversions could be advantageous during times when investments are particularly poised for growth. Paying taxes on the lower value—before the growth occurs—allows the appreciation to accumulate tax-free within the Roth IRA.

The fourth quarter is typically a good time for considering a Roth conversion because clients generally have a clearer understanding of their annual income and can more accurately assess the tax implications of a Roth conversion. Converting a Traditional IRA to a Roth IRA will require tax payments on the converted amount in the year of the transaction. This period also enables clients to offset gains with losses in their taxable portfolios through tax loss harvesting, potentially reducing the tax burden of a Roth conversion.

For clients concerned about Income-Related Monthly Adjustment Amount (IRMAA) for Medicare, year-end planning allows them to manage their MAGI (Modified Adjusted Gross Income) more effectively. And clients can use charitable contributions as part of their year-end strategy to offset some of the tax liabilities incurred from Roth conversions.

As a financial advisor, your knowledge and guidance through the intricate process of converting a traditional IRA to a Roth IRA is invaluable. Emphasize the benefits of future tax-free withdrawals and legacy planning. And advise your clients on the importance of timing—and specifically why the fourth quarter is an advantageous period. You will not only be helping your clients make informed decisions, you’ll be enhancing their financial flexibility in retirement.