Roth IRAs are very popular for many reasons: qualified withdrawals from Roth IRAs are not taxed, there are no required minimum distributions from Roth’s once you reach age 70 ½, and there is no age limit for making a Roth contribution. The problem that many taxpayers run into is that there is an adjusted gross income limit for making Roth contributions that phases out beginning at $186,000 for married couples and $118,000 for singles in 2017. This income limitation makes Roth IRA contributions off limits for many taxpayers. In a Roth conversion, traditional IRA contributions are converted to a Roth IRA, and there is no income limitation for a conversion. Here are a few of my favorite scenarios for a Roth conversion.
Another case where a high-income taxpayer can make efficient use of Roth conversions is in a year where they have lower than normal income, and they have made deductible traditional IRA contributions in previous years. This situation will often be due to net operating losses in the case of self-employed individuals. With individuals who generally have a lot of investment income, they could have a year with net capital losses rather than gains. In these cases, the taxpayer could find themselves in the unusual position of being in a lower than normal tax bracket. In typical years, the high-income taxpayer may be in the 33%, 35% or 39.5% bracket. In a loss year, they could find themselves in the bottom of the 10%, 15% or 25% bracket. The strategy is to convert as much of the traditional IRA to a Roth IRA as possible while still staying in that reduced tax bracket. Unlike the “backdoor” conversion discussed previously, this conversion is a taxable event because the traditional IRA contributions were tax deductible. The amount converted will be added to taxable income in the year of conversion. The key is to take full advantage of the lower income tax bracket and pay 10-25% tax rather than the taxpayer’s usual 33-39.5%.
Elderly taxpayers - If elderly taxpayers begin to incur high medical expenses, including nursing home care, they can find themselves in the position of having no taxable income due to the very high medical deductions. In this situation, they can convert amounts from traditional IRAs to Roth IRAs to maximize use of the 0%, 10% and 15% tax bracket. When the heirs inherit the Roth IRA, the heirs will not pay any income tax on the Roth IRA distributions. In contrast, if the heirs inherit a traditional IRA (deductible contributions), the distributions would be taxed at the heirs’ ordinary income rate. If those heirs are in the 33-39.5% tax bracket range, the tax can be significant. If the elderly taxpayer is able to do the Roth conversion while staying in the 0% tax bracket, nobody ever pays tax on the distribution.
These are just a few examples of the effective use of Roth conversions. Many more apply to specific taxpayer situations. There are also some specific rules that apply to conversions so make sure you have a full understanding in order to avoid costly mistakes. It is an excellent time to consider if a Roth conversion is right for you because 2017 conversions need to be completed by December 31, 2017. If you want more information, contact your tax advisor or one of us here at Mason + Rich.