Unintended Consequences of Roth IRA Conversions
Roth IRA conversations are among my favorite discussions to have with clients. I tout the long-term savings opportunity because of the tax favored nature Roth provides. Following strict rules, Roth money can enjoy compounded tax-free growth, be withdrawn tax-free and is not subject to Required Minimum Distributions in retirement years. Anyone with earned income is allowed to make an annual contribution of the lesser of their earned income or the maximum amount allowed for their given age. My husband and I feel so strongly about the power of Roth that we had our sons begin their contributions with their first year of W-2 income.
A Roth IRA conversion is different than a Roth IRA contribution. A conversion takes money that already exists in a pre-tax Traditional IRA and converts those dollars to a ROTH IRA. Ordinary income taxes are paid on the entire amount converted in the year of the conversion. In addition to the tax favorability mentioned above, conversions can be a way to hedge against potential rising tax rates and lower overall future taxable income which in turn can potentially lower social security taxes and Medicare premiums for years to come. Some utilize Roth opportunities as part of their estate planning strategy, paying taxes now so beneficiaries can escape taxation later.
But sometimes, there can be inadvertent effects. We used to have an “undo” button where conversions could be recharacterized before the end of the tax year, but congress took that away from us with the Tax Cuts and Jobs Act of 2017, becoming effective in 2018. Once converted, money must now stay in the Roth IRA. The conversion is added to ordinary income in the year of the conversion, so it can increase that year’s effective and marginal tax rates. Since Medicare premiums are based upon your modified adjusted gross income, you could pay more for the social insurance program if you are 63 or older, because Medicare premiums are based on your income from two years prior. Similarly, if you purchase insurance on the exchange, the amount you pay could also be more. Increased income could trigger AMT, or Alternative Minimum Tax. If you took a distribution within five years of making a conversion or if you were under 59 ½, you could end up foregoing the tax benefit of the Roth IRA dollars withdrawn. Or, if you’ll have lower income in retirement than you did when making the conversion, you could have potentially ended up paying higher taxes on the conversion than you otherwise would have on the distribution.
There is a lot we think through before pulling the trigger on a conversion. For some, it is a crystal-clear benefit. For others, there could be unintended consequences of Roth IRA conversions.
