By Cheryl Winokur Munk
Nov. 2, 2021
Now could be a good time to think about converting your traditional individual retirement account into a Roth IRA. That’s what more advisors have been telling clients these days, given a perfect storm of events that could make prompt action more important than ever.
Converting from a traditional IRA to a Roth IRA has been a strategy used for many years by people who make too much money to open a Roth initially or who make too much to contribute outright to an existing Roth. While converting means an upfront tax bill, any subsequent earnings will be tax-free within the Roth IRA and upon withdrawal, provided you meet a requisite holding period.* Converting to a Roth also means no required minimum distributions at age 72, so the money can grow tax-free for longer, which may appeal to those who don’t expect to need the money in retirement.
But there are potential regulatory changes in the works that make converting now even more compelling, advisors say. One of these is that Congress has been seriously mulling income tax hikes, which would make converting now, while rates are lower, more appealing. On top of that, Democrats have proffered plans to eliminate certain leniencies that currently allow investors who couldn’t otherwise contribute to a Roth IRA to benefit from these accounts.
While there’s a lot of horse trading going on with respect to these proposals, advisors are still recommending that many of their clients at least consider converting some of their retirement savings to a Roth.
Potential tax hikes. Democrats have been clamoring to raise taxes to fund social programs and have set forth several proposals to accomplish that goal. One option on the table is to raise the top individual income-tax rate to 39.6% from 37% for singles with annual incomes of more than $400,000 and couples earning more than $450,000. Another option being floated would make the top rate for the ultra-wealthy even higher.
The 37% rate, which was introduced in 2018 by the Tax Cuts and Jobs Act, is scheduled to sunset and return to 39.6% in 2026, but Congress could accelerate this move. That’s where advisors say some clients might do well to convert now, before rates return to higher levels.
“We are suggesting that higher earners who fall near the current 35% rate or higher consider a Roth conversion to take advantage of this year’s lower tax rate,” says Philip Herzberg, a certified financial planner and lead financial advisor at Team Hewins in Miami.
Of course, while rising tax rates are a concern, advisors also caution investors not to let the tax rules push them to do something that might not otherwise make sense. For example, they shouldn’t convert, if they have to use their IRA funds to pay the upfront tax bill, which can be hefty. They also don’t necessarily have to convert all their monies to a Roth IRA.
Pam Lucina, chief fiduciary officer at Northern Trust Wealth Management, says she’s seeing a lot of partial conversions since rules could always change again. “They’re trying to diversify and hedge,” she says.
Backdoor IRAs could be eliminated. There are other factors at play in why now may be an ideal time to convert. House Democrats have proposed eliminating popular strategies that have helped many investors who couldn’t otherwise invest in a Roth IRA do so. These backdoor approaches would be eliminated either in 10 years, or at the end of this year, depending on the strategy.
According to the latest publicly available proposal from the House Ways and Means Committee, Roth conversions would no longer be allowed for IRAs and employer-sponsored plans for single taxpayers, or taxpayers married filing separately, with taxable income over $400,000, married taxpayers filing jointly with taxable income over $450,000, and heads of households with taxable income over $425,000. These changes would take effect at the end of 2031.
The threat of no longer being able to convert may be enough to get people who have been on the fence to act. Kathleen Stewart, wealth strategist at BNY Mellon Wealth Management, says she’s had many clients contemplate converting in the past, but they’ve been too “skittish about paying the taxes” to act. “However, the markets have had a good run, and many investors have seen their after-tax accounts accumulate sizable gains,” she says. Accordingly, some may now be more comfortable paying the taxes at the current rates. This could be a sizable savings considering rates are expected to rise. They may also want to avoid the possibility that they won’t be able to convert at all.
“I think Congress putting a potential window on conversions may help folks address this sooner than later,” she says.
Democrats have also proposed prohibiting any after-tax contributions in qualified plans or IRAs from being converted to a Roth—regardless of income level. These changes would take effect at the end of this year. This is a way to close the loop on strategies such as the mega-backdoor Roth, where retirement plan participants whose plans allow it can roll their after-tax contributions into a Roth IRA tax-free. High-balance retirement accounts have been under the microscope since the news site ProPublica reported that business mogul Peter Thiel had accumulated $5 billion tax-free in a Roth IRA.
“Anyone who has a substantial after-tax balance in a 401k should see what their options may be to convert to a Roth IRA before year-end,” Stewart says. “If they are still working, they need to check with their employer to see what’s possible under their plan,” she adds.
Tax savings for heirs. In addition to these potential changes, there’s another reason to consider Roth conversions now. The Secure Act of 2019 requires beneficiaries to empty their inherited retirement account within 10 years. It used to be that non-spousal heirs could take distributions over their lifetime, allowing them to spread out the tax liability.
Now that this window has been shortened to 10 years, parents who are hoping to leave money to their heirs in a tax-advantaged way may have more incentive to do so, says Lucina of Northern Trust Wealth Management. She also encourages clients to consider state taxes since some states tax IRA conversions. If you’re considering moving to a state that does this, you may be better off converting before you move. “A lot of people miss the state tax implications and they matter,” she says.
*Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period.
Dow Jones & Company, Inc.