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When Does a Roth IRA Conversion Make Sense?

Posted by Lori Fogle on Wed, Aug 05, 2020 @ 12:00 PM

There are a few factors that make converting a Traditional IRA to a Roth IRA more ideal. Currently, amid the pandemic, we have a combination of factors that have created a bit of a silver lining for those considering a conversion.

In this post, we’ll dig into when it makes sense to do a Roth IRA conversion and 3 reasons why it’s worth having a conversation with clients about it right now.


First, lets define a Roth IRA conversion. A conversion takes money from a Traditional IRA where any contributions are income tax-deductible but where distributions during retirement would be taxable and converts it to a Roth IRA where contributions are made with after-tax money so that when the rules for a Roth IRA are followed, it grows income tax free and qualified distributions would be income tax free in retirement.

Clients should keep in mind that taxes on the amount converted to a Roth IRA would be due in the tax year the conversion takes place. So for example, any conversions done January 1, 2020 through December 31, 2020, would be added to ordinary income when clients file their taxes in 2021.  Contributions, funded with after tax dollars, may be made up to the filing deadline for that tax year. For example, 2020 Roth contributions could be made up until the filing deadline of 2021. 

So, when does it makes the most sense and when is it even more advantageous for a client to do a Roth IRA conversion? That’s what we’ll cover in this post.

1. When at a lower tax rate

If clients feel taxes will go up in the future, they could be better off doing a Roth IRA conversion now. With the current state of the world and of the economy, as well as the need to offset trillion-dollar stimulus programs, many predict taxes will go up in the future. If that does happen, the amount owed on any conversion or amounts taken out of pre-tax retirement savings could be more in the future.

Additionally, some of your clients may have less income this year due to unemployment, reduced hours, or no bonus or raise-- this reduces their taxable income and might allow some room for their taxable income to increase with the conversion and still be manageable.

We’re also still under the Tax Cuts and Jobs Act until almost all provisions expire after 2025. The TCJA shifted the thresholds for some income tax brackets, lowering tax rates for the time-being. This is another reason it may make sense for clients to consider a Roth IRA conversion right now.

One of the benefits of a Roth IRA is the confidence in KNOWING how much will be owed in taxes while letting gains grow income tax free. On the other hand, with a Traditional IRA, the amount that will be owed in taxes during retirement is based on what the tax rate will be at that time, which is yet to be determined.

You may be thinking that converting now results in few dollars working for your client. For example, if a client converts a $100,000 IRA and pays 25% between federal and state taxes, they will only have $75,000 working for them going forward. That's a real concern for anyone, right? Maybe it shouldn't be. 

Let's examine the math in a hypothetical example. Using the Rule of 72, we know that an account will double in 10 years at a 7.2% compounded rate of return-- $75,000 would grow to $150,000 in that case and $100,000 would grow to $200,000! That's a significant difference. At least until you pay the taxes...

Applying the same 25% combined federal and state tax rate, $200,000 becomes $150,000 after tax. It's the same outcome! However going forward, any interest or gains on the after-tax money will be subject to tax as well. That is not the case on a Roth IRA. 

So, it makes sense to ask-- Will my effective tax rate be greater in the future or not? If the answer is yes, it may make sense for a client to consider converting some of their Traditional IRA.

2. When a Traditional IRA balance has dropped

For many, the market hit their accounts hard and this can obviously be devastating. However, a reduced balance can be viewed as an opportune time to consider a Roth IRA conversion.

Since a client would owe taxes on the amount converted, a lesser balance means less taxes due. That said, not every client will want to convert the entire amount of the Traditional IRA. There are a select few insurance carriers we work with that would allow a client to make partial conversions over a period of time into one contract and spread out their tax liability. Doing partial conversions can also be a good plan with large Traditional IRA balances. 

3. When no Required Minimum Distributions (RMDs) are required

We are facing a rare situation in 2020 where individuals of RMD age are permitted to waive their RMD. Typically, an RMD must be taken in the year a client reaches age 72 (70 1/2 for folks who were already required to take a RMDs prior to the passing of the SECURE Act in December 2019 or who have Inherited IRAs) and every year after and that amount is taxable to the client. What makes this a potential drawback when it comes to doing a conversion is that a client would have to take an RMD first before they could do a Roth IRA conversion—increasing their taxable income even more.

This year, however, a client would have the option to only be responsible for paying taxes on the conversion (if they chose to do one) and not an RMD on top of that.

Once it’s converted to a Roth IRA, another advantage is that there are no RMDs on the Roth IRA while the owner is alive. Therefore, clients aren’t forced to take money out if they don’t need it.

Why a Roth IRA Conversion + a Fixed Indexed Annuity = an Even Better Combination

Not only does the Roth IRA itself offer many benefits for the right client, putting it into an FIA could be especially beneficial. Along with normal advantages to an FIA like downside protection and growth potential, you can also add an income rider.

An income rider allows a client to grow their income account value by a set percentage called a rollup rate, regardless of how an index like the S&P 500 performs. That income account value is then used to determine the amount of income a client would receive in retirement.

Most financial professionals understand that an income rider, by design, provides income a client (and sometimes a spouse) cannot outlive. But what they may not realize is that if the annuity contract is a Roth IRA, all the income for life payments would be income tax free.

If a client chose not to convert a Traditional IRA all at once, depending on the carrier, they could still take advantage of this by opening an FIA with their Traditional IRA and adding an income rider to begin payouts in 10 years, for example. Then they could strategically convert the annuity account value (not income account value) over a period of years (say from 2020 through 2025 under the TCJA) using a carrier that allows for partial Roth conversions within one contract, resulting in a lifetime of tax-free income.

In Conclusion

If you have clients wondering about how to improve their retirement outlook and find the positives in the current situation, it might make sense to introduce them to the idea of a Roth IRA conversion. And if you’d like to discuss fixed indexed annuity products that could make this even more appealing to clients, reach out to Partners Advantage today. This is a conversation with your clients that you do not want to put off.

Tags: Roth IRA, Roth Conversions

Please remember that converting an employer plan account or traditional IRA to a Roth IRA is a taxable event. Increased taxable income from the Roth IRA conversion may have several consequences including (but not limited to) a need for additional tax withholding or estimated tax payments, the loss of certain tax deductions and credits, and higher taxes on Social Security benefits and higher Medicare premiums. Be sure to have your clients consult with a qualified tax advisor before making any decisions regarding an IRA. An income rider or benefit (sometimes called Guaranteed Lifetime Withdrawal benefits, or GLWB) is an additional feature available with some annuities and generally optional and come with additional costs. Income benefits are designed to provide income options above and beyond the standard annuitization or free withdrawal features in annuities.

The tax and estate planning information contained herein is general in nature, is provided for informational purposes only, and should not be construed as legal or tax advice. Partners Advantage does not provide legal or tax advice. Partners Advantage cannot guarantee that such information is accurate, complete, or timely. Laws of a particular state or laws that may be applicable to a particular situation may have an impact on the applicability, accuracy, or completeness of such information. Federal and state laws and regulations are complex and are subject to change. Changes in such laws and regulations may have a material impact on pre- and/or after-tax investment results. Partners Advantage does not assume any obligation to inform you of any subsequent changes in the tax law or other factors that could affect the information contained herein. Partners Advantage makes no warranties with regard to such information or results obtained by its use. Partners Advantage disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information. Always consult an attorney or tax professional regarding your specific legal or tax situation.


This content is for informational and educational purposes only and is not designed, or intended, to be applicable to any person's individual circumstances. It should not be considered as investment advice, nor does it constitute a recommendation that anyone engage in (or refrain from) a particular course of action.