The Roth IRA is a perk-rich retirement vehicle. Among the many benefits of Roths, users can contribute after-tax dollars to these accounts and that capital then goes on a tax-free basis. Plus, Roth IRAs do not have required minimum distributions (RMDs) for the initial accountholder.
Another positive with Roth IRA is that the money can be bequeathed tax-free to heirs. That is to say Roths offer hedges for both accountholders and heirs against future tax increases. Then there’s the added flexibility for retirees.
“Mixing how you take withdrawals between your traditional IRAs and 401(k)s, or other qualified accounts, and Roth IRAs may enable you to better manage your overall income tax liability in retirement,” according to Fidelity. “You could, for example, take withdrawals from a traditional IRA until your taxable income reaches the top of a tax bracket, and then take additional money you need from a Roth IRA.”
Also on the list of Roth goodies are the ability to use contributions at any time and the ability to continue adding to these accounts provided the accountholder is working. However, there are some conversion conundrums clients should be aware. Enter advisors.
Drilling Down on Roth Conversion Agenda Items
It’s accurate to say that Roth IRAs are tax-advantaged vehicles, but Uncle Sam always has to wet his beak. Said another way, there are some tax obligations associated with Roths, but those can be offset in a variety of circumstances.
As Bill Cass, director of wealth planning at Franklin Templeton, points out, some Roth conversion tax situations are highly germane to business owners, particularly those with pass-through entities (sole proprietors, LLC members and S-Corp). Cass notes owners involved with those corporate structures may be able to leverage business operating losses to offset some of the income derived from Roth IRAs.
“A net operating loss (NOL) may occur during a tax year when business deductions exceed income, resulting in negative income,” he says. “While business owners would prefer to avoid losses, sometimes realizing a business loss is inevitable given economic or personal circumstances. Under current tax rules a NOL, if generated, generally must be carried forward to future tax years. Subject to applicable tax rules and limitations, business losses may help offset income generated from a Roth conversion, potentially reducing the current tax cost while creating a source of tax-free retirement income in the future.”
Interestingly, medical expense can also be part of a Roth income tax offset strategy. Currently, taxpayers can only deduct unreimbursed medical expenses if those costs surpass 7.5% of adjusted gross income (AGI), but there are some potential benefits for seniors.
Cass floats an example of a retiree in a nursing with AGI of $60,000 per year, out of pocket medical expenses of $120,000 and $500,000 in a traditional IRA. In this situation, this an advisor could execute a traditional-to-Roth conversion “while generating little or no additional federal income tax liability” and, in certain situations, possibly leave what’s left over in the Roth to heirs in tax-efficient form.
Consider Being Charitable
It’s nice to be charitable, but there are some restrictions on the tax benefits one receives for donating to charity. Basically, the deductions on large donations boil down to a maximum of 60% of modified adjusted gross income in a given year.
For high-net-worth clients planning sizable donations, it’s worth noting that’s an opportune time to boost a Roth IRA’s income profile.
“Generating additional income through a Roth conversion in a year when a large charitable gift is made may allow a taxpayer to make fuller use of available charitable deductions and potentially reduce the amount carried forward to future years,” concludes Cass. “It may make sense to convert Traditional IRA assets to a Roth IRA during a year when large charitable gifts are made.”
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