Time to convert your traditional IRA to a Roth?

Many high-net-worth individuals convert traditional IRAs to Roth IRAs as a way to shield heirs from future tax liabilities and avoid mandatory minimum withdrawals – but proposed federal legislation threatens to stop these practices.

Is it time to convert my IRA?  The short answer is maybe. It all depends on your particular situation, but the following is some guidance to help you decide.

What is Congress proposing?

Congress is looking to curtail the so-called Backdoor Roth IRA and Mega-Roth Conversion strategies.

Because most individuals with incomes over $120,000 are not eligible to contribute to a Roth IRA and annual limits on the allowable contributions to IRAs, it is challenging to build value in the tax-advantaged ROTH IRA accounts.  The Backdoor Roth and Mega Conversions are strategies to maneuver around those restrictions. 

Backdoor Roth conversions involve funding a traditional IRA funded with after-tax dollars (non-deductible), so there is no additional tax liability when you convert the account to a Roth IRA because you have a tax basis in the IRA.

• Under the proposals supported in mid-September, these types of conversions would be prohibited beginning next year. This would apply to everybody, regardless of income.

Mega-Backdoor Roth IRA conversions generally involve more significant balances involving a traditional IRA funded with pre-tax income -- meaning the investor received a deduction or a deferral of tax on their contribution.  Most common are individuals who roll over their 401(k) or 403(b) balances to IRAs at retirement.  These accounts, which can be large, are then candidates to be converted to ROTH IRAs. 

Converting an IRA funded with pre-tax contributions to a ROTH IRA requires the value of the IRS to be included in taxable income in the year of conversion.

Because these conversions are revenue generators, the proposed legislation would allow them to continue for the next 10 years. However, in 2022, taxpayers with income over $400,000 if single and over $450,000 if married would be unable to convert pre-tax dollars. This restriction would eliminate many who have historically used this conversion feature.

Conversion advantages and disadvantages

Potential advantages to conversion in 2021:

• Accelerating the income on the IRA value today may allow the income taxes on the conversion to be excluded from your estate, assuming you live for three years.  In the case of mega backdoor conversions, while you have an immediate tax liability, your heirs will avoid having to pay income taxes on the account. Many clients believe the top marginal tax bracket will be lower in 2021 than in the future and want this benefit even if it is 3-to-5 percent. 
• Roth IRAs are currently not subject to required minimum distributions. The future appreciation of the Roth IRA will avoid income taxes under current law.

Potential disadvantages:

• You are accelerating income tax on the value of the IRA today most likely at a high marginal tax rate. There may be advantages to spreading the income tax over many years, or your future tax liability could be reduced or avoided if you:
  • Name a charity as a beneficiary.
  • Have high medical costs that defray some of your future taxable income.
  • Experience a significant income tax loss on business investments.
  • Have heirs in a lower marginal tax bracket.

• Future legislation may claw back the tax-free advantages of the Roth IRA 

Making the choice

Most clients converting in 2021 are doing it as an estate-planning maneuver to alleviate their heirs' income taxes and allow them to benefit from future appreciation.  But there is no escaping having to pay the income taxes up-front on a conversion.

Because everyone’s situation is different, you should consult with your accountant or investment advisor.

However, it is wise to recognize that Roth conversions are on Congress’s radar. If you have been considering a Roth conversion, 2021 may be your last window of opportunity. 

 

Thomas J. Taricani, CPA/ABV, CVA, CEPA, is a principal of Boyer & Ritter providing audit, accounting, tax, and consulting services. His specializations include formulation and implementation of succession and estate plans, and preparation of business valuations of closely held businesses for use in succession, estate planning, and various litigation engagements. Contact Tom at 814-234-6919 or ttaricani@cpabr.com.