Trump Tax Cuts and 11 Other Reasons to Skip Roth Conversion

It may be a good idea to prepay income taxes into a retirement account. Or it could be a really bad idea. Read this before pulling the trigger.

_With_{William Baldwin}_{Senior Contributor}

toour financial advisor You may be excited about paying taxes up front on an IRA and converting it to a completely tax-free Roth IRA. Is this a great idea? Sometimes. Not always.

The recent election of a tax cutter to the White House should have dampened the enthusiasm of Roth fans. One of his claims was that the lower tax rates implemented under President Trump in 2017 are scheduled to expire at the end of 2025, so you shouldn’t miss the opportunity to prepay. Now there is a good chance that low rates will be extended. There is less reason to rush.

The transition of power in Washington to President Trump and Republican control of both the Senate and the House of Representatives is just one thing that will make you re-examine Roth’s transformation plan. A conversion cannot be undone. Before you continue, see if any of these 11 reasons not to Rothify apply to you.

1. You use part of the IRA to cover the tax bill.

This defeats the purpose of conversion.

Example: You are and will be in the 30% bracket (combined federal and state). Converting now leaves $70,000 in the account while withdrawing $30,000 for taxes. Let’s say the portfolio doubles when you withdraw the money. You now have $140,000 in spending money. But if there were no conversion, your $100,000 would double to $200,000, and you’d have the same $140,000 after taxes.

What did you gain by converting: nothing. Why bother? Why subject yourself to the disadvantages of conversion (see #2 through #11 below)?

There are hypothetical situations in which you could be successful in using the $30,000 in the account to pay taxes, but they are not worth the mental effort.

For comparison, look at what happens if you use outside money to cover the tax bill. You take the $30,000 you have, plus the $100,000 in pre-tax retirement shelter, and turn all of that into a $100,000 after-tax shelter. It doubles to $200,000. In fact, your $30,000 in spending under shelter grows to $60,000. So, you used this conversion to protect the $30,000 previously incurred in annual tax losses.

This trick, stashing away $30,000, is the essence of what makes a Roth conversion smart, at least for the majority of taxpayers who don’t benefit from a temporarily lower bracket.

Rule of thumb: If you can’t cover the tax bill from outside the account and there’s no reduction in your tax rate, don’t convert.

2. Your estimated tax payments were low.

Your withholding tax plus quarterly estimated taxes for this year may not have allowed any conversion. Now dive in and increase your income by $100,000 (in our example) and you could owe a penalty. Take a look before proceeding with a conversion.

If there will be a penalty for underpayment, conversion may still make sense. But maybe it’s not worth doing all the arithmetic to find out. Instead, give yourself some time to transform next year.

Adjust next year’s quarterly estimated taxes so that your payments equal 110% of this year’s tax total. This safe harbor means you can get any size increase in income without incurring underpayment penalties. Of course, 110% coverage only affects the timing of tax bills. You still owe $30,000, but you can pay it off in April of next year.

3. You donate.

Once you turn 70-1/2, you can skip your tax return and send money directly to a charity with a pre-tax IRA. Maximum: $105,000 per calendar year.

Therefore, you should leave an amount equal to the donations you will make for 20 years without conversion. (Let’s assume you live to be 90.) If you find that you can’t maintain your generosity when you’re 83, not converting won’t do you much harm. You’ll withdraw the money for yourself and pay your taxes then instead of today. You’ll just be missing the shelter upgrade described in #1 above.

4. You are planning to make a charitable donation.

Assets left in an unconverted IRA are ideal for matching a donation to a charity. The charity inherits the money you never paid without having to pay income taxes on it. Discuss this with your estate planner.

Let’s say you have $2 million, half is in a pre-tax IRA, the rest is not. You want to leave $1 million to your granddaughter Sally and everything else to the Red Cross. It may make sense to name Sally as the primary beneficiary of the IRA and the Red Cross as the contingent beneficiary, while also directing your administrator to let Sally choose which assets she receives. Depending on what happens to your portfolio when you die, Sally will likely decline most or all of the IRA to obtain assets with no income tax liability.

5. Your IRA beneficiaries are in a low tax bracket.

If you name, say, your six grandchildren as beneficiaries, they will all be starving artists. They can spread withdrawals over ten years and pay income taxes on the inherited pre-tax IRA at lower rates than you would pay on a conversion today. Don’t convert that money.

6. You are moving.

If you’re planning to move to Texas, it would be foolish to convert while in California and pay California income taxes on the money.

7. You may have a gap year.

Let’s assume that if you are fired, it will take seven months for you to get a new job. This low-earning, low-level year would be a better time to convert. What are the chances of such a misfortune? How secure is your employment? If you work for a tie manufacturer, you should probably hold off on the conversion for now.

8. You are near the top of a group.

It rarely makes sense to convert so many times that you roll over your taxable income to the next bracket. keep an eye out at breaking points.

For example, the 24% federal rate applies to married couples with adjusted gross incomes of roughly $230,000 to $412,000 this year (exact amounts depend on your circumstances). For singles, cut those numbers in half.

Taxpayers over age 63 also need to be wary of Medicare premium surcharges. These are not as significant as tax brackets, but they add up to thousands of dollars. There are AGI dividing lines for a couple at $258,000, $356,000 and various other places. Complex formulas are detailed Here.

9. You may need a nursing home.

Here we’ll assume that (a) you’re pretty well off and (b) you’re smart enough to never buy a long-term care policy. You have a pile of money that you probably won’t need and will probably pass on to your heirs. But you use it for nursing care. This amount should be left unconverted.

From where? If you develop Alzheimer’s disease, your guardian may marry a taxable withdrawal (or conversion) from the IRA with a tax deduction for medical expenses.

10. You collect dividends.

An additional tax of 3.8% applies to the lesser of two figures: (a) the amount of investment income such as dividends, interest and capital gains; (b) the amount by which adjusted gross income exceeds $250,000 (joint return) or $200,000 (single return).

“Investment income” is defined to exclude payments and conversions from IRAs. However, the formula is created in such a way that some transformations are indirectly affected.

Let’s say you have $240,000 in adjusted gross in joint returns, and $40,000 of that is dividends. Now you add a $50,000 conversion. This puts all your dividends into the additional tax category. In effect, four-fifths of your conversion is subject to an extra 3.8% rate.

Calculate your noninvestment income, which includes salary, pension, and mandatory IRA withdrawals starting at age 73. If this amount is above the $250,000 or $200,000 threshold, you can ignore the 3.8% surtax. If it’s lower, you’ll need to do some calculations before deciding how much to convert.

11. You may need money soon.

Withdrawals made within five years of conversion may subject you to taxes or penalties. The complex rules are outlined in a chart on page 32 of the IRS. Publication 590-B.

One of the more interesting rules about Roth accounts is that taxation depends on whether you’ve had a Roth account of any size for at least five years. This particular rule means that if you don’t already have a Roth account, you should create one tomorrow, even if it’s only with a token amount in it.

What is the Value of a Conversion?

Question to consider: How big is the return on converting an IRA to a Roth IRA? It could be a nice change. But probably not as big as the Roth evangelists would like you to believe.

One benefit comes from bracket arbitrage. If you can fit your taxable income into a low-income year, say, between jobs or between retirement and starting Social Security, you’ll come out ahead. Not everyone has this opportunity. There’s also a lot you can do before you throw yourself higher and beat the arbitrage.

The other benefit described in the main story of issue 1 relates to housing money used to pay the urgent tax bill. In our example, $30,000 was withdrawn from a taxable brokerage account for this purpose.

To illustrate the payoff, we will imagine two middle-income taxpayers. They both invest in a stock index fund that has doubled in 12 years, meaning its annual return (with dividends) is just under 6%. In the calculations here, it is assumed that the part coming from dividends is the current return of the stock market.

If Samantha decides not to Rothify, she invests the remaining money after all that into more shares of the index fund, paying the 15% federal rate plus the 3.8% investment surtax plus the 6% state rate each year. At the end of 12 years, the fund converts its appreciated shares into cash and pays the same rates on capital gains. $30,000 turns into a little less than $53,000. With the transformation strategy, he would have $60,000.

Benjamin pays a 15 percent federal and 6 percent state rate on dividends but is not subject to additional tax (this tax affects married taxpayers starting at $250,000 of adjusted gross income). Twelve years from now he will be run over by a motorcycle on West End Boulevard. His widow, who is enjoying the increase in fund shares, has just over $58,000 to spend.

Is there a fee for Rothifying? For these people, yes. But it’s not a huge amount.

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