Broker Check

Roth Conversion Puzzle

| December 01, 2017

No one can predict the future. Considering the uncertainty of these economic times and what the future may hold for most Americans with respect to tax brackets and deductions, having a potential pool of retirement income with low to no related tax liability could represent a prudent tax diversification strategy. Making employee after-tax contributions to a qualified plan is one way to potentially build a source of income in retirement with little tax impact. We previously wrote on the power of the Roth(k), so I will review some pertinent parts of that discussion. I will also add a few new wrinkles that you should consider, some ideas you may not have thought about yourself.

What are the Types of Qualified Accounts?

There are generally two different types of IRAs/qualified plan contributions – pre-tax (traditional) contributions, or after-tax (Roth) contributions. With traditional contributions, you are able to exclude the portion of your income from current taxation, allow the contributions to grow tax deferred, and pay ordinary income tax upon withdrawal. You are able to do so through a traditional IRA (assuming you meet certain income/age/contribution limits) or through a qualified plan at work, like a 401(k), 403(b) or 457 plan.

On the other hand, you may also be able to make Roth contributions to a Roth IRA or qualified plan. With Roth contributions, the money is contributed after tax (so you are taxed on your contributions), grows tax free and you are able to withdraw the money tax free as well (both principal and growth). Again, you can do so through either a Roth IRA (again, subject to certain income/age/contribution limits) or through Roth contributions if such contributions are allowed through your workplace plan.

What Should I Choose?

People who are in their peak earning years just prior to retirement generally stand to benefit most from traditional contributions. In such high earning years, traditional contributions could take you into a lower tax bracket and have a significant impact on your tax bill. When you distribute the money out in retirement, presumably you will be in a lower tax bracket, thus you are able to benefit from deferring your taxes (including annual dividends/interest and avoiding the 3.8% ObamaCare surtax on investment income) and a lower tax bill when you distribute the money out.

Individuals new to the workforce fall on the other end of the spectrum. Incomes are smaller, so contributions are smaller, and tax consequences are smaller as well. During those early earning years, there’s less need to move down to a lower tax bracket, so it generally makes sense to make Roth contributions, which can enjoy the power of compounding. When such individuals make distributions in retirement, they will enjoy tax free withdrawals on a large account due to compounding (and a smaller tax bill overall). 

If you’re between 35 and 55, the prudent decision is a gray area, as tax and income situations vary widely. Tax laws may also change drastically by the time you retire, so there isn't a perfect plan for deciding on Roth, traditional, or blended contributions.

Should I Convert My Pre-Tax Money?

Many of you may in fact be aware of the information provided in the above paragraphs. There are a few additional intricacies in these rules which allow for some unique planning opportunities.

First, I would point out that if you leave your employer, you generally are able to rollover your Roth(k) contributions to a Roth IRA. This may not be surprising to you – rollovers of like taxed qualified assets are nothing new.

However, in 2008, there was an additional wrinkle added. If it is your prerogative to tax diversify and you would like a Roth but do not hit the income thresholds ($133,000 for individuals and $196,000 for couples in 2017), you may be able to convert a portion of your pre-tax or traditional qualified plan money directly to a Roth IRA. There is typically a “trigger” in the plan which allows you to do so (severance of employment, or the plan offers “in service” distributions while you are 59 ½ and still working, which 81% of plans offer).[1]

This makes for a very interesting tax play: if you a) have left your current employer and have excess cash and expect a low income year or b) you are 59 ½, still working for your current employer and expect a low income year, you can decided to convert some or all of your pre-tax qualified plan money directly to a Roth IRA. While you will have to ante up on the tax in that year, such qualified plan money will be taxed at a lower tax bracket (since you have lower overall income). In doing so, you will go to lengths to be tax diversified, and you receive many of the benefits of having a Roth IRA:

  • The Roth IRA will grow tax free and can be withdrawn tax free
  • You are not subject to required minimum distributions at 70.5
  • You can leave a tax free asset to your children/heirs

A Few Other Conversion Nuggets

The IRS also allows in-plan Roth conversions. If your qualified plan so allows, you are able to convert any portion of your pre-tax qualified plan money into a designated Roth account within the 401(k), allowing you to reap the Roth benefits (of course, you do need to pay the tax in the year of conversion).

In a 2013 AON survey of 400 employers representing over 10 million employees last fall, Aon found that over the previous six years, the percentage of employers that allow Roth contributions (a prerequisite to allowing in-plan conversions) has increased from 11 percent to 50 percent. And 27 percent of those plans that allow Roth contributions allow in-plan Roth conversions. Another 16 percent of companies were planning to add the conversion feature within the next 12 months – thus, this could be a tremendous opportunity going forward.

I would like to point one more consideration for a possible Roth conversion. Many of you who are clients know full well of the non-deductible IRA, whereby you put in money after tax, it grows tax deferred, and you pay tax on the gain. Well, these accounts also have the opportunity to be converted immediately – thus, you can make an after tax contribution to a N/D IRA, convert it immediately to a Roth IRA (I.E. a few days later), and you have now magically taken an account that will be taxed in the future to a Roth, which will not be taxed in the future – its tax magic!

Consult a Professional

As you may have noticed, many of these options are only available if your plan so allows; thus, it is important to understand the specific language within your qualified plans, so a professional review of your plan is paramount. I am always here to help, so if these strategies may be of interest to, please feel free to reach out to me or Anthony at any time.

Karen DeRose and Anthony DeRose are registered representatives of Lincoln Financial Advisors Corp.

Securities offered through Lincoln Financial Advisors Corp a broker/dealer (Member SIPC) and a registered investment advisor. DeRose Financial Planning Group is not an affiliate of Lincoln Financial Advisors Corp. Lincoln Financial Advisors does not provide legal or tax advice.