Are You in the Roth Conversion Zone?

Christine Benz: Many investors wrestle with whether to convert their traditional tax-deferred assets to Roth. I recently chatted with Vanguard senior investment analyst Maria Bruno about considerations to bear in mind before converting.

Maria, thank you so much for being here.

Maria Bruno: Thank you, Christine.

Benz: You did a blog post where you talked about converting traditional IRA balances to Roth. And you talked about how year-end can be an opportune time to take a look at this. Why would that be? Why would year-end be a good time of year to take a look at that?

Bruno: The conversion window was really on the calendar year. If you've been thinking about converting, you have until the end of the year to do it for 2017. The reason why I like to bring it up as part of the year-end checklist is that you, at that point, probably have a pretty good idea of what your income picture looks like for the year. That can give you a sense in terms of, one, if you've been thinking about converting, should you do it and how much. Because there's some thought there in terms of not doing too much of a conversion to pop you into a higher marginal bracket, but maybe just some flexibility there. Or alternatively, if you're in an atypical situation and you're in a low tax bracket year, you might want to convert more.

The end of the year is usually a good time to think through that. There's always the opportunity to recharacterize. In 2018, if you realize that you might have some regret there or it may be higher than you thought in terms of taxes, you could always recharacterize that as well, too. So, some flexibility is afforded as well.

Benz: Recharacterize simply means I want to do that over, I want to undo the conversion that I said I wanted to do before.

Bruno: Yes, absolutely. There's this flexibility in that if you do convert, you have until, technically have until Oct. 15 of the following year, to actually unwind a part or all of that conversion if you change your mind.

Benz: Let's quickly just get into the virtue of doing a conversion. If you have these traditional IRA or 401(k) balances, the benefit of converting is tax-free withdrawals and no RMDs, right? Those are the two mains things?

Bruno: Yes, those are the two big ones, yes.

Benz: No required minimum distributions. But the downside as you've alluded to is that you have to pay taxes on the amount that you convert. Let's talk through that.

Bruno: Right. If you're working, obviously you can channel your contributions accordingly either to Roth accounts or traditional deferred accounts. Once you are retired, for instance, or if you have large balances maybe from a 401(k) rollover, you might want to think about opportunities to convert. Essentially, what you are doing there is taking a distribution from that traditional IRA and then paying any potential incomes taxes on that. In fact, it's actually added to your income. You want to be careful if you are under the age of 59 1/2, penalties may apply. But if you are past that window, it's a good opportunity to think through how to achieve that tax diversification, but you are accelerating the income tax liability. You are doing that for a future economic benefit of no taxes on the earnings going forward, no lifetime RMDs, and there's some other benefits to Roths as well.

Benz: When you say tax diversification, the reason I want to focus on that as I'm accumulating assets for retirement is that when I'm in retirement, I actually have some choices about the tax treatment of the various assets that I'm pulling from.

Bruno: Correct. It's almost like asset allocation where you hold different asset classes to diversify against different market activities. It's the same thing around tax uncertainty. We don't know what the future tax landscape will look like, but by holding different types of accounts, whether they are taxable nonretirement accounts or traditional deferred accounts or Roth accounts, the tax treatments are different. You can be strategic when you are in retirement how to draw down. Or if you are thinking about leaving legacy assets or charitable contributions or things like that down the road, having these different account types can really give you a lot of flexibility to do that individual decision-making.

Benz: In your blog post, you wrote about some strategies that people might use to help reduce the tax hit associated with doing conversions. Let's talk about how charitable contributions can work in this regard.

Bruno: Anyone who is charitably inclined, and you make qualified contributions, you get the benefit of a tax deduction for that contribution. If you think about a Roth conversion, you're actually increasing your taxable income. If you can offset that with a charitable contribution, for instance, that can help minimize the tax liability for your overall tax picture.

Qualified charitable contributions are typically capped at 50% of your adjusted gross income. If you're very charitably inclined and you are hitting that cap, if you think about a Roth conversion, you're increasing your income and then you are cap go up a bit as well, too.

Benz: I see.

Bruno: There's some flexibility there to actually be able to contribute more to a charity if you're thus inclined.

Benz: Another tip that you have is that you should manage your low marginal tax bracket years. What does that mean?

Bruno: It's an interesting one and I think one that we may be seeing more of from retirees today as they enter retirement maybe in their 60s. Before they reach age 70 where distributions are mandated from their tax-deferred accounts and also for those that have deferred Social Security, they could be facing a pretty big tax liability once they reach age 70 1/2. So, they may well relatively be in a lower tax bracket, either of 65 to 70 or 60 to 70, we call that the Roth conversion zone. Because we are actually seeing with some of our shareholder activity that Roth conversions are increasing up to age 70. That leads us to think that individuals are taking advantage of these unique years potentially to accelerate some taxable income, potentially in a series of Roth conversions to create that tax diversification.

Benz: The reason that they would want to look at those years is that they actually have some control over their tax bracket in those years. If they are not earning a salary anymore that they may be able to be in a relatively lower tax bracket than they would be later on?

Bruno: Correct, right. Yes, maybe they are not having earned income or maybe a part-time income, their marginal tax bracket may be lower. There may be unused dollars, meaning, you might be in a 28% tax bracket, for instance, hypothetically. And maybe there's some room there that if you incurred additional income, that income would be taxed at 28%. You are using the full benefit of that low tax bracket. Maybe later, you might be in a 40-plus tax bracket. It's taking that benefit of those lower marginal brackets and incurring additional income to take advantage of that tax rate.

Benz: You also wrote in the blog post about how this is an instance where being subject to the alternative minimum tax could actually help you out a little bit if you wanted to do a conversion. Let's talk about how that would work and the AMT, of course, is a terribly complicated, but if you can maybe give us short form?

Bruno: At a high level, AMT was put in place to make sure that high income individuals pay their fair share of taxes. It's been a little tough over the years because that figure hasn't been indexed for inflation. There have been some AMT patches throughout the years where they are adjusted that threshold. But the reality of it is, more and more individuals may be subject to AMT where they thought they weren't necessarily subject to that parallel tax, and it is a parallel tax.

The thing to keep in mind is, if you are actually subject to AMT, you may be paying a lower tax rate. For instance, your marginal rate maybe 40%-plus, but the AMT rate is either 26% or 28%. There is a window there in terms of this income threshold that if you are subject to AMT, much like filling up the marginal brackets that we just talked about, there's this AMT envelope where additional dollars would be taxed at 28%. That may be an opportunity to actually convert a little bit more than you may have thought. However, you need to be careful because if you convert too much, then your income jumps right back up to the high marginal bracket that you're taxed otherwise. It can get a little complex or a lot complex. Tax software can help guide you through that because you can do some what-if planning with tax software. But certainly, if you're subject to AMT, it is something that you want to think through with your tax advisor.

Benz: Let's discuss some of the pitfalls to watch out for if you're doing conversions because there are obviously a lot of moving parts to this is. What are some of the key things that people should have on their radar?

Bruno: Well, the one would be if you convert too much. You do have the opportunity to recharacterize that next year. There's some flexibility there. The one thing that I like to talk about that I don't think we talk about enough in the industry is for individuals that are Medicare eligible, so Medicare Part B. Medicare Part B premiums are based upon income thresholds. Depending upon what your income is for a particular year, your Medicare premiums will be based upon that income. If you think about a Roth conversion, let's use 2017 for an example. If I do a Roth conversion this year, the income that I earn this year will be filed in 2018. But that number will actually be used to determine what my 2019 Medicare Part B premiums would be.

Here is the situation where it doesn't manifest itself really until two years later, and at that point, it's too late to be able to recharacterize anything. I may have increased inadvertently my Medicare premiums for 2018. It's a planning nuance there that I like to bring up for individuals who are Medicare-eligible to make sure that they understand what their tax picture looks like, what their income picture looks like and not to discount in terms of what it could impact to Medicare.

Benz: This seems like yet another reason to maybe get some help on this decision-making if you're thinking through conversions and whether they would be beneficial for you?

Bruno: Yeah, I think so. I think for those individuals that are in that spot, and that spot may be 65 to age 70, for instance, before distributions start from their IRAs or 401(k)s, there are some planning opportunities there you do want to pursue with caution. You want to be thoughtful and working with an advisor could be a big benefit there.

Benz: OK, Maria. Complicated topic. Thank you so much for being here to unpack it for us.

Bruno: Thank you. Thanks for having me.