Morningstar - Winter 2019 - 45

Revisiting Roth Conversions
Now may be the time to go all in.

TAX WISE

Sheryl Rowling

Roth IRA conversions might seem like old news,
but today's tax and economic environment
warrants a fresh look at the benefits of converting
a traditional individual retirement account
to a Roth. As always, a client's changing needs
may alter the analysis and make conversion
suitable where it wasn't before. What's new is the
likelihood of rising tax rates down the road
and a rocky stock market. This combination makes
conversions particularly attractive for many
retirement savers today.
First, a review to illustrate the advantages of
a conversion: Traditional IRAs, as well as
employer-sponsored SIMPLE IRAs and SEP-IRAs,
are funded by pretax dollars. Because the funds
generated a tax deduction upon original
contribution, they are taxed upon withdrawal.
Additionally, although capital gains and income
are tax-deferred inside an IRA, withdrawals
are taxable in full at ordinary income tax rates.
Roth IRAs are almost the inverse of IRAs.
There is no tax deduction when contributions are
made to the account. However, withdrawals
are completely tax-free (assuming the account
has been in existence at least five years).
In other words, a Roth owner never pays tax on
the account's earnings.
There is one other major difference between
Roth IRAs and IRAs: IRA owners must take
required minimum distributions, or RMDs, once
they reach age 701/2, even if they don't need the
cash flow. That results in regular taxable
income recognition. Because RMDs are not
required for Roth IRAs, these accounts can earn
tax-free returns over a longer period of time.

Conversion Considerations

Subject to income limitations, the maximum
allowable contribution is $6,000 per year for those
under age 50 and $7,000 for those 50 and
older. But as of 2010, taxpayers can convert an
unlimited amount of an IRA balance to a Roth.
That comes with the cost of recognizing
taxable income in the amount of the conversion-
but it also means the permanent avoidance
of tax on future growth in the account. For those in
middle and high tax brackets, the decision of
whether and how much to convert to a Roth can
require a complex cost/benefit analysis.
Sometimes, however, the answer is easy.
For any taxpayer with a year of negative taxable
income, it makes sense to do a Roth
conversion to the extent that no tax is generated.
This may occur during a year when itemized
or standard deductions exceed income,
or when there are substantial business losses

or net operating loss carryforwards. In my
opinion, any financial advisor or CPA who fails to
recommend a Roth conversion in a year
of negative taxable income could be subject
to a malpractice claim.
For those in a low tax bracket, it might make
sense to convert an amount that will take
full advantage of the lower bracket. For example,
a single taxpayer might want to convert an
amount that will bring taxable income to $39,475,
the top of the 12% bracket in 2019. Or a client
with negative taxable income of $11,000
might choose to convert $50,000 of IRA savings
to a Roth IRA, resulting in taxable income
of $39,000 and a federal tax of only $4,680. This
is a very reasonable price tag to be able to
fully avoid tax on principal and earnings forever.
A recent wrinkle: To qualify as a Roth conversion,
the transfer must occur by the end of the
year-and as a result of the Tax Cuts and Jobs
Act of 2017, recharacterizations after year-end
are no longer allowed. Before the act, taxpayers
could "unconvert" part or all of the transfer
by recharacterizing it before the due date of the
tax return (including extensions). So, in the
above example, if the client converted $50,000 and,
upon preparing the tax return, discovered
that taxable income was $10,000 higher than

EXHIBIT 1

Roth Conversion Guidelines There is no bright-line rule; each client's situation and
preferences will guide the decision.

In Favor of Conversion

gClient has outside funds to pay taxes
gClient is willing to write a check to the IRS
gMarginal tax rates will increase in
the future	
gCash flow from IRA not required
in retirement
gFamily will inherit the account

Against Conversion

gClient without funds to pay taxes
gClient unwilling to write a check to the IRS
gMarginal tax rates will decrease in
the future
gCash flow will be required in retirement
gAccount is willed to a tax-exempt
organization

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