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Robert Bloink and William H. Byrnes

Financial Planning > Tax Planning

Don’t Overlook Post-Retirement Roth Conversion Benefits

By William H. Byrnes By Robert Bloink

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What You Need to Know

  • After retirement, clients are likely to be in a lower income bracket and thus owe less in taxes on the coversion.
  • Roth conversion are also a way to, in effect, prepay estate taxes for heirs.
  • Clients must be careful to keep the converted money in the Roth account for five years before withdrawing it.

Most advisors understand the importance of talking with clients about the benefits of executing Roth conversions as part of an effective retirement income planning strategy during their working years. Discussing the pros and cons of the Roth conversion strategy once the client has actually entered retirement is much less common.

For the right client, though, a series of Roth conversions can add significant value, in terms of improving income options and tax situations during retirement and furthering estate planning goals. The need to identify tax-savvy financial planning strategies doesn’t disappear once clients stop working, and in-retirement Roth conversions may be a smart move.

Cash and Tax Bracket Control

Retirement can be an ideal time to execute Roth conversions because clients may be in a lower tax bracket when compared with their prime working years.

As an initial matter, it’s important to remember that when traditional IRA funds are converted to Roth funds, the entire amount converted is taxed as ordinary income. If the client doesn’t have sufficient cash on hand to cover the tax liability, the Roth conversion is rarely advisable. Clients with enough cash on hand to cover expenses (in addition to tax liability) during the year of conversion also have the best odds of being in the lowest tax brackets — reducing the overall tax cost of the conversion.

The client’s age is also important. If clients have retired but are not yet subject to required minimum distribution rules on traditional retirement accounts, they have more control over their income levels for the year of conversion. The same applies to clients who aren’t yet claiming Social Security benefits.

The Roth conversion itself can also serve to reduce the value of taxable RMDs once the client does become subject to those distribution rules.

Building a Roth account can also serve as a hedge against potentially higher future tax brackets. For example, if the client anticipates selling a business or another asset at some point during retirement, the Roth can be drawn upon to control overall taxable income during that year to potentially avoid jumping into a higher tax bracket.

Clients, however, should remember that they must wait five years before they can withdraw the amounts that have been converted — meaning that the funds converted will be locked into the Roth for at least five years, or the client will incur a 10% penalty on the amounts withdrawn. That five-year clock starts running on Jan. 1 of the year the client executes the Roth conversion.

Estate Planning Workaround

Roth accounts are also a much more valuable estate planning tool today. Post-Secure Act, most beneficiaries of traditional retirement accounts must empty the account within 10 years of the original owner’s death — and pay the associated tax bill during that period. If the original owner died after the date that RMDs began, beneficiaries will also be required to take annual RMDs during years 1-9 after death. Any remaining amounts must be distributed in year 10.

With Roth IRAs, on the other hand, beneficiaries are not required to take required minimum distributions during that 10-year period, although the account must still be emptied within 10 years of the original owner’s death. Even when beneficiaries do withdraw the funds, they won’t have to pay taxes because they also inherit the benefit of tax-free withdrawals.

Clients who have accumulated large balances in traditional IRAs before entering retirement may be attracted to this strategy because it essentially allows them to prepay beneficiaries’ taxes at a time when the owner tends to be in a much lower tax bracket than beneficiaries are expected to be in their prime working years when they inherit the account.

Conclusion

As is the case with clients who are in their working years, it’s important to evaluate their big picture to determine whether a Roth conversion strategy might make sense during retirement.

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William H. Byrnes

Robert Bloink

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