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Roth has been a buzzword in the industry since its creation, and 2021 shined an even brighter light on it. Between Peter Thiel’s $5 billion Roth account and political fighting over back-door Roth contributions in the proposed Build Back Better legislation, this topic is top-of-mind for consumers and advisors. But the focus has been on how to get as much money in a Roth as possible, but that is not a universally great idea.
Here are five reasons not to recommend a Roth conversion to your clients.
1. Shadow taxes – “We’ll just fill up the 24% tax bracket.” Marginal income tax rates get all the attention when deciding whether to do a Roth conversion and the amount to convert. However, federal income tax rates are not the only consideration. Because a Roth conversion is included in adjusted gross income, there are other costs associated with intentionally adding income to a tax year. The two biggest are the Medicare Income Related Monthly Adjustment Amount (IRMAA) and the Premium Tax Credit (PTC) established under the Affordable Care Act. These are often called “shadow taxes” because they do not follow the standard income tax brackets. If you have a client who is impacted by either, they need to be thoroughly considered before moving forward with a Roth conversion.
2. There is no “undo” button – Unlike IRA distributions that can be paid back or rolled over within 60 days, a Roth conversion is final. Once a Roth conversion is complete there is no going back. This is especially relevant in years when a taxpayer is close to a threshold for shadow taxes or other eligibility limits. It is dangerous to guess where a taxpayer’s income will end up if you are making Roth conversions, because you have no flexibility to adjust. If the taxpayer is in a relatively low bracket that you want to help them take advantage of, consider an IRA distribution near the end of the year instead. This gives you a 60-day window to evaluate their final income situation for the year and “rollover” excess amounts back into a qualified plan, taking the excess amount out of income.
3. The taxpayer doesn’t have cash flow to cover the tax bill – The goal of a Roth conversion is to get as much money as possible into a tax-free account. While not prohibited, having taxes withheld from the conversion causes the taxpayer to miss out on some of the potential benefit of this strategy. This doesn’t mean the taxpayer has to write a single check for the taxes. Consider other sources of income they have and whether withholdings can be adjusted to cover that additional tax of the conversion. For taxpayers who are still working, updating a W-4 to increase withholdings from their wages is one easy way to do this. Especially for taxpayers under the age of 59 and a half who are still subject to the 10% penalty on early withdrawals, not having outside cash flow to cover the taxes on a conversion significantly changes the ultimate benefit of the strategy.
4. The taxpayer doesn’t want to do it – This typically comes up either because the taxpayer doesn’t understand the strategy or because they just hate paying taxes. Like any planning strategy, Roth conversions have to be done in a way the client is committed to following through. Their understanding is a matter of effective communication. For most taxpayers this is not about endless case studies or scenario analysis identifying the optimal amount to convert. It can be as simple as, “Mr. and Mrs. Client, there are three options for what might happen to tax rates in the future. They could go up, they could stay the same, or they could go down. The IRS has given us an option to pay taxes now and let your money grow tax free in the future, which means you come out ahead if tax rates go up and break even if tax rates stay the same. The only way this is a negative is if tax rates go down. Are you worried that might happen?”
When it comes to taxpayers who are adamantly opposed to paying taxes now, one successful approach used by Micah Shilanski, CFPⓇ is to ask, “How much would you be comfortable paying in taxes right now?” This changes the conversation to figuring out what will be successful for the client and what they will follow through on, instead of simply focusing on the best quantitative scenario.
5. Lifetime planning of wealth – To make an informed recommendation on Roth conversions, you have to understand the long-term implications for a specific taxpayer. This includes their legacy planning for the lifetime of their wealth, not just their personal lifetime. For a taxpayer who expects to have wealth at the end of their life and leave it to charity, aggressively pursuing Roth conversions will lessen the impact they can have on the organizations they plan to support. Like so many areas of tax planning, there are other factors to consider. Even for taxpayers who plan to leave everything to charity, they could end up in a punitive required minimum distribution (RMD) situation. By proactively making Roth conversions now they can lower the total tax they would pay compared to waiting until larger amounts have to be taken into income through RMDs.
While a powerful tool, Roth conversions are not a universal solution to reducing taxes. Great advisors understand the limitations but consider this strategy for their clients, even if that action is the dishwasher rule (letting your clients know you’ve reviewed their situation and that the strategy is not a fit for this year but that you will continue to watch for it in the future).
Steven A. Jarvis, CPA, MBA, is CEO and head CPA of Retirement Tax Services.
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