What you need to know
- Currently, the conditions for Roth conversions are ripe.
- Clients should finance the tax liability with non-IRA funds.
- Keep in mind that a client’s tax bracket could be significantly lower at the time of retirement.
While establishing a non-taxable source of retirement income is generally a smart game for every client, there are some clients who will benefit more dramatically from Roth IRA conversion strategy – and time is important.
Given the current political climate, chances are high that this year will be the right time for clients to maximize the benefits of Roth conversions. Realistically, we are almost certain that we will see some sort of income tax increase in 2022 – if not sooner – and with the economy recovering from hopes of vaccine effectiveness, happy customers could even increase revenue in the coming months.
Currently, the conditions for Roth conversions are ripe – and clients should be advised who can benefit most from Roth’s conversion strategy to avoid leaks once this unique window is closed.
Reasons to consider Roth’s 2021 conversion strategy
As most clients know, Roth IRA funds grow tax-free and withdraw tax-free during retirement. However, only clients with income below a certain amount can invest funds after tax directly to Roth. Clients with higher incomes can finance Roth by converting traditional IRA funds (usually paid before tax) and paying taxes on the converted amounts in the conversion year.
Currently, income tax rates are at historically lowest levels according to the tax reform legislation from 2017. Almost all of Biden’s pending proposals involve raising the maximum income tax rate to pre-reform levels – meaning clients will pay more conversion taxes if (and when) those proposals become law.
Nevertheless, clients should carefully assess their personal financial situation before making a conversion. It is important to examine both the current financial framework and potential future changes in the client’s circumstances that could affect the value of the conversion today.
Practical considerations when considering Roth conversion
A non-taxable source of income should be part of any well-diversified portfolio. It is impossible for anyone to predict the future with 100% accuracy. Tax rates may increase – or the client may find himself in need of additional funds during retirement. The Roth IRA offers a non-taxable source of income to allow clients to control their taxable income later in life to avoid jumping to a higher tax bracket due to an unexpected financial need during retirement.
Clients who anticipate higher tax rates or expect to be in a higher tax bracket in the future can turn their tax liability into a conversion. That way, they can pay taxes at the current lower rates – freeing up more funds for additional pension savings.
In this regard, it is always best to fund the tax liability with non-IRA funds. Clients who have to rely on IRA funds to pay Roth conversion taxes basically pay tax on the converted funds they use to pay taxes.