44 INVESTMENT ADVISOR JANUARY/FEBRUARY 2021 | ThinkAdvisor.comretirement accounts can provide flexibility for your clients in helping them formulate a retirement withdrawal strategy.
ROTH CONVERSION DISADVANTAGES
Sometimes a Roth conversion may notmake sense, or at least careful analysis isrequired. Most of these decisions involvethe merits of paying taxes now in exchangefor the benefits of a Roth IRA in the future.
When considering a Roth conversion,it’s important to look at thepotential payback — specifically, the amount of taxes thatwill be due on the conversionupfront compared to the client’s life expectancy. This isespecially crucial for a clientwho is 60 or older. An analysis needs to be run to analyzea potential break-even pointwhere the benefits of doingthe conversion outweigh the currenttaxes due on the conversion.
Clients may want to do a Roth IRAconversion as part of their estate planning strategy. This is a prime example ofwhere all of the pros and cons of the Rothconversion need to be weighed and discussed with your client. The estate planning benefits need to be weighed againstthe current-year taxes on the conversion.
Even for clients who are 59 ½ orolder, the five-year requirement forqualified distributions remains in effect.In the case of Roth IRA conversions,there is a separate 5-year rule for eachconversion that starts on Jan. 1 the yearthe conversion occurs. If your clientneeds to take a distribution from theconverted funds prior to the completionof the 5-year window, any earnings willbe subject to taxes, and if your client isyounger than 59 ½, penalties as well.
The extra income generated from
the Roth conversion could bump clients
who are on Medicare into a higher cost
bracket for their Medicare Part B ben-
efits. For those receiving Social Security,
the extra income may cause a higher
percentage of their benefit to be subject
to taxes in the year of the conversion.
ROTH IRA CONVERSION STRATEGIESDoing a Roth IRA conversion when assetvalues in a client’s traditional IRA arelow can provide them with “more bangfor their conversion buck.” For example, a conversion during stock marketdeclines, like last March, would allowa client to potentially convert a higher percentage of their traditional IRA,offering the potential for this depressedamount to appreciate tax-free in theRoth account over time.
1. Backdoor Roth IRA. The backdoor Roth is a popular strategy for thosewho earn too much to contribute to aRoth IRA. To work, your client makesan after-tax contribution to a traditionalIRA and then immediately converts thisto a Roth IRA.
This gets trickier if clients have othermoney in a traditional IRA that includespretax contributions and earnings. Inthis case, the amount converted will betaxed as a percentage of the after-taxcontributions to the pre-tax contributions and earnings.
2. Mega Backdoor Roth IRAConversion. This strategy allows yourclient to contribute up to $38,500 onan after-tax basis to their employer’s401(k) and then convert this money toa Roth IRA at some point in the future.This amount is reduced by any matchingcontributions made by their employer.
Your client’s 401(k) plan must allowafter-tax contributions above the
$19,500 or $26,000 (for those who are
50 or over) contribution limits. The
maximum total contributions allowed
to a 401(k) for 2021 are $58,000 and
$64,500 for those who are 50 or over.
If the client’s employer allows in-ser-
vice withdrawals, your client can roll the
after-tax money to a Roth IRA doing the
Roth conversion with little or no taxable
income. An alternative, if their employ-
er allows this, is to transfer the extra
after-tax money to a designat-
ed Roth account within the
401(k) plan. The money is still
in a Roth account where it
can grow tax-free. When your
client leaves their employer,
they can then roll the funds
in the Roth 401(k) over to a
If their employer doesn’tallow in-service withdrawalsthen your client will have to wait untilthey leave the employer.
3. Inherited IRAs. The Secure Actchanged the rules for inherited IRAs formost non-spousal beneficiaries. With afew exceptions, non-spousal beneficiaries must withdraw the entire amountof the inherited IRA account within 10years of receiving it. In the case of atraditional IRA, this means paying taxeson the value of the account. In the caseof beneficiaries who are adults in theirpeak earning years, this can be a largetax hit that was not anticipated by theaccount owner.
With an inherited Roth IRA, the same10-year rule still applies. However, thedistributions will be tax-free to theaccount beneficiaries as long as theaccount holder held the assets in aRoth IRA for at least five years prior totheir death.
Roger Wohlner is a financial writer whobrings his experience as a financial advisorto his writing. He ghostwrites extensivelyfor financial services providers, investmentmanagers and financial advisors.
When considering a Roth
conversion, look at the potential
payback — specifically, the
amount of taxes that will be due on
the conversion upfront compared
to the client’s life expectancy.