Strategies for annual Roth conversions

March 13, 2019

 

Key highlights

Tax-savvy annual planning may ease the tax bite of Roth conversions.
Strategies include: Pair partial conversions with charitable giving, make full use of low marginal income tax rates, plan within the Alternative Minimum Tax envelope, and take Social Security income taxation into account.
 

Note: As part of our Vanguard Advisor's Alpha® initiative, we are presenting three articles focused on using Roth accounts as part of estate planning. This article is the last in a three-part series on using Roth IRAs to maximize wealth transfers. The first article can be found here, and the second article can be found here.

Roth accounts can help clients reduce taxes in retirement and help them pass greater wealth on to their heirs. But converting a large amount at once could trigger a large tax bill and even push clients into higher tax brackets.

The way to avoid that scenario is to begin a strategy of annual Roth conversions, perhaps even years in advance of a client's retirement, says Garrett Harbron, senior manager, Vanguard Wealth Planning Research.

Harbron said the following techniques could help advisors execute an annual Roth conversion plan:

  • Offset conversion income tax through charitable contributions. Charitably inclined individuals can consider planning annual gifts around Roth conversions. Charitable contributions may typically be deducted up to 50% of adjusted gross income.1 Because a Roth conversion increases adjusted gross income, clients can potentially make larger deductible charitable contributions in the year(s) they convert. This can further their charitable-giving strategy and reduce the tax impact of their Roth conversions at the same time.
  • Maximize full use of low marginal tax brackets. Some individuals may find that their income is lower in the earlier years of retirement, before required minimum distributions (RMDs) and Social Security benefits start. This may be an optimal time to convert.2 They can take full advantage of their lower marginal income tax rates during these years by doing a series of partial conversions to "fill up their tax bracket," in other words, to bring taxable income to just below where it would trigger the next highest tax bracket. Similarly, years in which clients have large tax deductions that place them in a lower tax bracket than normal can also offer excellent conversion opportunities.3
  • Consider converting if clients are paying AMT. Individuals subject to the Alternative Minimum Tax (AMT) may be able to reduce the taxes they pay on a conversion. Their AMT rate4 will likely be lower than the marginal income tax rate they would pay otherwise. Depending on circumstances, the conversion amount could be taxed at the lower AMT rate as opposed to the higher rate. Working closely with a tax planner can help clients strike the right balance between converting as much as possible and still remaining within the AMT envelope.
  • Check into the effect of receiving taxable Social Security benefits. Up to 85% of Social Security benefits may be taxable,5 depending on income. Because of the way this is calculated, taxpayers only slightly above the threshold can pay a significantly higher marginal tax rate. Individuals in this situation may choose to convert some traditional IRA assets. This will not lower their overall tax bill, but it may lower their marginal rate.

Capitalizing on tax planning opportunities can help amplify the benefits of a Roth conversion, but careful planning is needed. Converting too much in a given year can eliminate the benefit of these strategies and could even increase the taxes clients would otherwise pay. The additional income from a Roth conversion can significantly affect the taxability of Social Security benefits and Medicare Part B premiums, among other things. Clients should consult with a financial planning professional to help ensure they benefit from tax planning opportunities without incurring any unpleasant surprises at tax time.

Financial planning and wealth management should be approached comprehensively, taking into consideration an individual's specific circumstances and goals. In the context of an estate plan, the trade-offs of a Roth conversion heavily depend on the individual situation and may not be easily quantifiable. Although the principles outlined here can be a useful place to start, it is critical to consult with a qualified tax planning professional to ensure the full benefit of these strategies.

1 Certain contributions are limited to 30% of adjusted gross income. See IRS Publication 526 for more detailed information.

2 Vanguard's IRA Insights research has found that conversions rise between ages 60 and 70. We call this pattern the "Roth conversion zone."

3 Other industry experts advocate this strategy. For example, see Michael Kitces, https://www.kitces.com/blog/using-systematic-partial-roth-ira-conversions-and-recharacterizations-to-fill-the-lower-tax-bracket-buckets/

4 In 2018, the 28% AMT rate applies to excess AMT income of $191,500 for all married taxpayers filing jointly ($95,750 for individuals). For more information, see: https://taxfoundation.org/2018-tax-brackets/.

5 There are two tax thresholds for Social Security benefits. For 2018, 50% of these benefits are taxable for married couples filing jointly with provisional income between $32,000 and $44,000 ($25,000 and $34,000 for single filers). For married couples filing jointly with combined income exceeding $44,000 ($34,000 for individuals), 85% of Social Security benefits are taxable. Provisional income includes one-half of Social Security benefits plus all other income, including tax-exempt interest. It would not include, however, withdrawals from a Roth account.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest. We recommend that you consult a tax or financial advisor about your individual situation.
  • Withdrawals from a Roth IRA are tax free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both. (A separate five-year period applies for each conversion and begins on the first day of the year in which the conversion contribution is made.)

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