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Roth Conversion Strategies

July 16, 2019
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There are many reasons why advisors utilize Roth conversions to bolster a client’s success in retirement, so it is important to have a general understanding of the mechanics involved, why you would want to complete a conversion, and what types of market conditions help to optimize the strategy. Unlike a Traditional IRA account, there are income limitations that prevent single tax filers from contributing if MAGI (Modified Adjusted Gross Income) is over $137,000; married filing jointly $203,000. This can make it difficult for high income earners to accumulate significant ROTH balances, which can then be distributed tax-free during retirement. As a reminder, ROTH contributions are made with post-tax dollars and distributions that occur after age 59½ are penalty-and income-tax free. Furthermore, there are no required minimum distributions at the age of 70½. Two ways high earners can make Roth contributions are:

  1. Contributing to a Roth 401(k) account
  2. Completing what is often referred to as a “backdoor Roth IRA”

It is worth mentioning that unlike the Roth IRA, the Roth 401(k) has no income limit, so high earners can take full advantage. The “backdoor Roth IRA” allows people to circumvent the income limitations by making a standard non-deductible Traditional IRA contribution, and then converting the amount the following year into a Roth. Converting these dollars means that the funds are treated as ordinary income to the account holder in the year the transaction occurs. After the conversion, the funds are inside the Roth and can grow tax free for an indefinite amount of time. Remember that there are no required minimum distributions from a Roth account, and as long as the individual has earned income, they can continue to make contributions. Individuals’ tax circumstances are unique, but there are a few general concepts that can help clients determine if this is right for them. Consult with your tax advisor and find out if there is any room left in your marginal tax bracket to take on more income. For example, you may be able to take an additional $10,000 in your current bracket, so converting that amount to the Roth may make sense. That said, you must be aware not to create so much income from the conversion that it launches you into a higher bracket. Another good strategy is to be aggressive with conversions when there is a significant downturn in the market. If your investment account is down 30% and you convert, you will be taxed on the reduced value. However, once the funds are in the Roth they can grow back and reach new highs income tax-free. Again, it is critical to consult with your tax advisor or financial planner before implementing these strategies.