Sheryl Rowling

Implementing tax saving moves prior to year-end has become increasingly important to clients. Among the top indicators of the need to take action is when a client is subject to a low tax bracket. For clients in up to 15% tax brackets, it seems like a no-brainer to recognize capital gains at zero tax. Yet taking advantage of this opportunity is often not in the best interest of clients.

Using Roth conversion to zero out taxable income

The more beneficial strategy for clients in low tax brackets is Roth IRA conversion. If the investor holds appreciated securities through death, using the zero capital gains tax has no impact. If, however, the investor has IRA funds, converting to a Roth can permanently avoid taxes (ordinary taxes) that do not get eliminated at death.

Roth conversion analyses can be complex and can be made much easier with technology. Tax-planning software can help determine the true cost of a Roth conversion. Increasing adjusted gross income by Roth conversion amounts can increase taxes beyond simply multiplying the additional conversion income by the client’s tax bracket. Not only can the extra income put the client into a higher tax bracket, Social Security taxation can rise while itemized deduction benefits can drop (because of phase outs based on adjusted gross income). So, tax-planning software can be extremely helpful in determining how much to convert.

From a practical standpoint, at a minimum, Roth conversions should be recognized to the extent of negative taxable income. In other words, if gross income minus itemized deductions and exemption allowances nets to a negative number, Roth conversion income can be recognized up to an amount that would bring the net taxable income to zero at no tax cost.

This is a true gift from the IRS. Advisors who do not carry out Roth conversions for clients in a negative taxable income situation could actually be liable for malpractice, because missing that opportunity might be considered a violation of professional standards.

When is it better to increase Roth conversions?

When taxable income is zeroed out, the question becomes whether it is more beneficial to harvest gains or convert additional IRA amounts. Absent any contraindicators, it is typically better to increase Roth conversions. Some contraindicators include:

• Whether the client will be depleting IRA to fund living expenses.
• Whether the client cannot pay taxes on the conversion from funds other than the IRA.
• Whether the client is not concerned about the post-death tax burden on their heirs.
• Whether the client is planning to leave IRA funds to charity.
• Whether the client is not willing to pay conversion tax.

Why is Roth conversion better than gain harvesting?

Gain harvesting eliminates capital gains tax on accumulated appreciation that might be eliminated at death. Roth conversion eliminates ordinary tax on principal and future earnings at a low current tax cost. Clearly, the latter is a better deal. It should also be noted that Roth IRAs are not subject to required minimum distributions.

Finally, ideal holdings for Roth IRAs are very different than for non-Roth IRAs. Most advisors will place fixed income investments in IRAs to defer taxation. However, because Roth IRAs will never be taxed, it is better to hold highly appreciating positions in these accounts. So the best approach to Roth conversion is not to simply move IRA investments to the Roth. Rather, rebalancing across the client’s various accounts will produce the greatest benefit. To do this, software such as Morningstar® Total Rebalance Expert® can greatly assist with location optimization (asset location) for the switch.