Why Roth Conversions Are Not A One-Size-Fits-All Solution
From: www.fa-mag.com
Any client who hopes to maximize their retirement funds, you would be wise to explore Roth IRAs. Converting to a Roth IRA is an increasingly popular retirement strategy, but bear in mind it certainly isn’t a one-size-fits-all solution.
Potential Benefits Of Roth Conversions
Clients can transfer their funds from a traditional IRA or 401(k) into a Roth IRA through a Roth IRA conversion. Traditional IRAs give investors tax-deferred growth, but they still pay taxes upon withdrawal. On the other hand, while transferring funds to a Roth IRA incurs taxes, they can look forward to tax-free earnings and withdrawals in retirement.
Individuals need to think of their Roth conversion like an apple orchard that allows them to pay taxes on the seed, not the harvest. If you pay taxes on your contributions now through a Roth IRA, your future withdrawals are tax-free. This can be especially beneficial if the investments grow significantly over time.
Although we can’t guarantee what taxes will do in the future, we know they are at historic lows today and that the Tax Cuts and Jobs Act is set to sunset in 2026. Furthermore, considering the United States has accumulated a debt exceeding $35 trillion, most experts are confident that taxes will rise. By converting clients’ funds to a Roth IRA, they lock in today’s low rates and avoid potential tax increases down the road.
In addition to their tax benefits, Roth IRAs do not obligate individuals to begin taking required minimum distributions as traditional IRAs do. This increased flexibility enables them to continue growing your investments tax-free.
How Roth IRA Conversions Circumvent Costs Associated With High-Income Retirement
The Income-Related Monthly Adjustment Amount (IRMAA) is an extra fee that Medicare Part B and Part D enrollees pay if their earnings surpass specific limits. This additional fee is calculated using the earnings one reports two years before you enroll in Medicare. In other words, the amount they make at age 63 will impact how much they pay for Medicare when you turn 65.
Their IRMAA surcharge increases as their income increases. If they have been a diligent saver throughout their lives, they will likely face higher costs for Medicare, even though they receive the same benefits as someone who saved and earned less.
If they don’t go into retirement with a good strategy, the required minimum distributions from their traditional IRA retirement accounts can push them into higher IRMAA tiers. For this reason, age plays a crucial role in whether a Roth conversion makes sense. If you are under 63, the strategy is cleaner since you won’t need to worry about how it impacts your Medicare premiums. If you’re 63 or older, though, things get trickier. A financial advisor can help clients determine whether it’s worth inflating their income now and temporarily facing higher IRMAA surcharges or deferring the problem to the future when Medicare premiums are likely to rise.
Clients’ IRMAA is not the only concern. Medicare costs are projected to continue escalating, and the income brackets for IRMAA could potentially lower in the future. This makes it even more necessary to ensure a lower income in retirement.
Increased Medicare premiums may also reduce clients’ Social Security benefits. Medicare expenses are taken out of Social Security, so higher income brackets could result in receiving far less Social Security funds. This discouraging fact highlights the need to plan ahead to safeguard their Social Security benefits while reducing taxes and healthcare expenses.
Factors To Consider Before Roth Conversions
Despite the numerous advantages of Roth IRA conversions, several important factors must be considered. Before determining if a conversion is the right choice for an individual, first evaluate the taxes that they will incur. Since converting a traditional IRA to a Roth IRA means the converted amount will be taxed as current income, advisors must ensure they can cover this tax payment without dipping into their retirement savings.
Next, remember that Roth conversions involve a fair amount of complexity and potential for error because they involve more than simply moving funds from one account to another. Factors such as Social Security taxes, Medicare premiums, capital gains, and the five-year rule all complicate the process. Costly mistakes can be irreversible.
One final factor to think about is the tax bracket they anticipate being in during their retirement years. If you predict that they will be in a lower tax bracket, paying taxes now may not be beneficial. Conversely, if they anticipate higher income and tax rates, a Roth conversion might prove advantageous.
Personalizing Your Roth Conversion Strategy
Given the complexity of a Roth IRA conversion, personalized advice is key. Engage with financial and tax professionals who understand clients’ unique financial situation and can help them navigate the nuances of a Roth IRA conversion while minimizing their risk of costly mistakes.
Instead of converting a large sum all at once, professionals are likely to advise clients to consider spreading the conversions over several years. This could help manage their tax liability by keeping them in a more favorable tax bracket.
Financial advisors can also introduce clients to the financial planning tools that will empower them to project future income, tax rates, and investment growth. This can provide a clearer picture of whether a Roth conversion aligns with their long-term financial goals.
Finally, financial professionals can show individuals the best ways to maximize Roth IRAs in their estate planning. Unlike traditional IRAs, Roth IRAs do not require beneficiaries to pay taxes on inherited funds, and this allows them to leave a more substantial legacy.
While a Roth IRA conversion is a powerful tool for strategic tax planning that offers the potential for tax-free growth, avoidance of future higher tax rates, and greater flexibility in retirement, it’s not a decision to take lightly. Consult with financial and tax professionals for personalized guidance.
