Take-Away: With the current reduction in federal income tax rates due to the 2017 Tax Act, especially for married couples, now might be the good time for them to convert a traditional IRA to a Roth IRA. A Roth conversion makes the most sense if there is a strong belief that the IRA owner will be in a higher income tax bracket when retirement age is reached. Instead, if the belief is that the individual will be in a marginally lower income tax bracket in his/her retirement years, in that case retaining a traditional IRA makes the most sense.

Background: The benefits of a Roth IRA are well known: (i) a Roth IRA’s assets and the income they generate are exempt from federal and state income taxation; (ii) the owner of the Roth IRA faces no required minimum distributions from the Roth IRA; (iii) the conversion from a traditional IRA to a Roth IRA can be accomplished at any age without incurring the 10% penalty for that distribution [IRC 408A(d)(3)(A)(ii).] and (iv) in Michigan, Roth IRAs are exempt from creditor claims. [MCL 600.6023(1)(j).] The obvious drawback to a conversion of a traditional IRA to a Roth IRA is that the traditional IRA’s assets will be subject to income taxation in the year of the conversion. However, with today’s historically low income tax rates, exposing the IRA assets to taxation on a Roth conversion might make a lot of sense. In addition, with the current discussion in Washington about income tax increases, or the SECURE Act’s proposed maximum 10 year distribution of inherited IRAs, if the fear is that the IRA owner will be in a marginally higher income tax bracket in retirement, then converting to a Roth IRA when the income tax rates are lower is strategically sound.

Conversion Example:  A married couple in 2017 reports taxable income of $237,951. That couple would pay an income tax at the 33% federal income tax bracket in 2017. In 2019, the same married couple with the same taxable income of $237,951 would pay income tax at the 24% federal income tax bracket, i.e. 9% less in income taxes paid. If the married couple wanted to convert $83,000 of a traditional IRA to a Roth IRA in 2019, they would remain in the 24% marginal federal income tax bracket despite reporting that additional $83,000 as taxable income this year, with a reported total taxable income of $320,951.

Roth Conversion Reasoning:

  • Income Tax-Free: As noted, the income generated by the assets held in a Roth IRA are income tax-free. If that income is not required to meet cash-flow needs in retirement, the Roth IRA account balance will continue to grow. If distributions are required, e.g. large purchases, none of the distribution from the Roth IRA will, as a general rule, be taxed (but see below for exception.)
  • No RMDs: Unlike a traditional IRA, or qualified plan account e.g. 401(k), there is no required minimum distribution from a Roth IRA. However, the beneficiaries who inherit a Roth IRA will have to begin taking RMDs from the inherited Roth IRA. [1.401(a) (9)-5, Q&A-5(a) through (c). This obligation to take RMD’s from an inherited Roth IRA may become even more problematic if the SECURE Act becomes law and the inheritor must completely withdraw the balance of the inherited Roth IRA within 10 years of the Roth IRA owner’s death.
  • Possible Medicare Premium Benefit: The 2019 Monthly Medicare B premium is $135.50. It jumps 40% if the individual’s income is just one dollar above $85,000, or above $170,000 on a married individual’s joint return. It increases  from $135.50 a month to $189.60 a month. The Medicare premium can go as high as $460.50 a month. If a traditional IRA is converted to a Roth IRA, the individual might pay reduced Medicare premiums with lower reported income i.e. with no RMDs, unlike with a traditional IRA, there is less reported income on which the Medicare premium is based. Note, however, that in the year of the Roth IRA conversion, if the individual is then eligible for Medicare, the additional income reported caused by the Roth conversion could trigger a higher Medicare premium to be paid for the year in which the Roth conversion occurs.

Random Roth Rules: A variety of rules applies to Roth IRAs, pre- and post-conversion, that need to be factored into any decision to make a Roth IRA conversion.

  • No Re-characterization: One of the big changes caused by the 2017 Tax Act was the elimination of a Roth IRA re-characterization. A re-characterization occurred when a traditional IRA was converted to a Roth IRA, and the market value of the Roth IRA  promptly dropped, which resulted in paying income taxes (on the conversion) of phantom assets that no longer existed in the Roth IRA. A re-characterization permitted the owner to reverse the process, placing the assets from the Roth IRA  back into the traditional IRA, and then filing for an income tax refund. The 2017 Tax Act eliminated this ‘do-over’ which means that there is a risk associated with a Roth conversion if the stock market drops in value,  which will result in a payment of income taxes on phantom assets that no longer exist.
  • Roth 401(k) Accounts: A traditional 401(k) account cannot be converted to a Roth 401(k) account; conversions can only be made into a Roth IRA. Only IRC 408A addresses conversions to a Roth IRA. However, there is no income limitation if a plan participant [e.g. 401(k); 403(b); or 457(b)] contributes to a Roth 401(k) plan if the qualified plan permits Roth contributions.
  • Roth 401(k) RMDs: Roth 401(k) and Roth 403(b) accounts are subject to required minimum distributions. [IRC 402A (e) (1) (B).] However, this limitation can be easily circumvented by rolling the Roth 401(k) or Roth 403(b) account balance over into a Roth IRA where there is no lifetime required minimum distribution.
  • Earnings Limitations: High earning individuals cannot contribute to a Roth IRA. In 2019, an individual’s ability to contribute up to $6,000 to a Roth IRA (or $7,000 if over age 49) is restricted if his/her adjusted gross income is over $120,000. The adjusted gross income restriction is $193,000 if that adjusted gross income amount is reported on a married individual’s tax return. Roth IRA contributions are totally prohibited if the individual earns in excess of $135,000, or $203,000 is reported on a married couple’s 1040 income tax return. In contrast, there is no income limitation that prohibits a Roth IRA conversion.
  • Taxation of Roth Investment Income: For the distribution of investment income from a Roth IRA to be excluded from taxable income, the distribution: (i) must be made after the individual has attained age 59 ½ (or becomes disabled, acquires a first home, or dies); and (ii) more than 5 years after the individual made a contribution or conversion to a Roth IRA. [IRC 408A (d) (2) (B); Treas. Reg. 1.408A-6.]This 5-year fermentation period also applies to the taxation of investment income from a Roth 401(k), Roth 403(b) or Roth 457(b) plan. In other words, while income generated by a Roth IRA is normally tax-free, the Roth IRA must have been in place for at least 5 years. The 5-year rule is determined based on when the Roth IRA was first established- it uses actual calendar years, so that arguably the 5-year rule could be as short as 4 calendar years and one day, if the Roth IRA was opened on December 31 of one calendar year.
  • 10% Penalty Imposed on Roth IRA Distribution: There is a 10% penalty imposed if an individual under the age 59 ½ receives a converted amount within 5 years of the Roth IRA conversion. [IRC 408A (d) (3)9f); Treas. Reg. 1.408A-6, Q&A- 5(b) &(c).]
  • Roth Distribution Ordering Rules: While the distribution from an inherited Roth IRA could cause the inheritor or owner to pay income taxes, that risk is mitigated largely by the Roth IRA distribution ordering rules. A distribution from a Roth IRA is deemed to be first made from the tax-free principal amounts, so that the recipient of the distribution will not receive any taxable investment income until all tax-free principal (converted) amounts have been distributed.

Conclusion: A Roth IRA makes sense if the IRA owner expects income from retirement plan distributions to be subject to higher tax rates in future years during retirement. If the owner is so wealthy that federal estate taxes will be a concern, then a Roth IRA conversion also may make sense, as the owner’s estate will be reduced by the payment of income taxes on that conversion; stated another way, if a traditional IRA is held until death, estate taxes will have to be paid on the built-in income tax liability associated with a traditional IRA. While there is some relief from that ‘tax on a tax’ by virtue of IRC 691(c), that income tax deduction associated with the federal estate taxes paid on the retirement assets is only available to reduce the inheritor’s income tax liability associated with distributions from the inherited IRA, but that deduction will not help to reduce state income taxes assessed on the inherited IRA. A Roth IRA conversion may also make sense if the market drops in values, as the amount converted to the Roth IRA will be less, perhaps keeping the owner in a lower marginal federal income tax bracket even when the converted amount is added to the owner’s other taxable income. For these reasons, talking to clients about a Roth IRA conversion is timely as we begin to hear about tax increases in the run-up to the 2020 elections.