If your clients are like most American savers, they’ve used tax-deferred accounts to save for retirement.
And if they’re like a growing number of American savers, perhaps they’ve started to worry about the tax burden building up in these accounts.
As tax-free savings gain popularity, Roth conversions are a common topic for clients and their advisors to discuss.
But is your Roth conversion analysis complete? And once a client makes the decision to convert, do you know how to help them minimize tax and IRMAA impacts during that conversion?
There’s more to a Roth conversion than many savers realize.
Here are three areas of analysis you should be performing for your clients:
Evaluating Their Potential Roth Conversion
If your clients are considering a Roth conversion, they’re likely looking to reduce their tax burden in retirement. They may believe that taxes in the future will be higher than they are today, and therefore, want to take care of their tax responsibility now rather than later.
But evaluating - and reducing - their retirement tax bill requires three steps:
Evaluate Your Client’s Total Potential Tax Burden
Help your clients answer the question: Will I likely pay more total taxes if I keep my IRA or if I convert to a Roth account?
There is no way to know the exact amount of taxes any of us will owe in the future. However, for many savers - especially higher-net-worth savers - there are many indicators that taxes are going up.
So you can help your clients see the impact of both level taxes and rising taxes by evaluating their “Total Tax Burden” under two scenarios: keeping their IRA and converting it to a Roth IRA. (If you’re looking for software to make this evaluation easy, check out Stonewood’s tax analysis options here.)
This kind of analysis takes assumptions you and your client make together and projects the total potential taxes your client may owe in each scenario.
Evaluate Your Client’s Potential Tax Drift During a Conversion
Next, help your client answer the question: Will converting funds move me into a higher tax bracket during my conversion years, and if so, how much more will I pay?
Because funds withdrawn from a qualified account are taxable income in the year they’re withdrawn, savers will likely have additional taxable income in the years they convert. If that additional income pushes your client into a higher tax bracket, the portion of the converted funds in that higher bracket will have a higher tax responsibility.
This is what I call “Tax Drift,” and it can be an important measure to evaluate before converting. Often, your client may want to weigh any additional taxes paid due to tax drift against the potential modeled tax savings of their Roth conversion. This can give them a more complete picture of the tax implications of the conversion.
Evaluate the Impact of Government Fees and Surcharges on Your Client’s Conversion
There’s a final question we need to help our clients answer: Will converting funds impact the government fees I owe each year outside of taxes, and if so, by how much?
As we all know, certain government fees could be impacted depending on how a client manages their retirement accounts and the tax status of their savings.
Perhaps the most pressing of these - and one that many savers don’t fully understand - is IRMAA.
Once a saver elects to receive Medicare, they may be subject to surcharges for their Medicare Part B and Part D premiums. These fees – called the Income-Related Monthly Adjustment Amount, or IRMAA – are based on a saver’s modified adjusted gross income (MAGI). The higher the MAGI, the higher the IRMAA amount.
Your client’s MAGI could potentially change based on both the conversion process and the final landing place of their assets.
During the conversion years, your client could find their IRMAA fees are higher if the additional income from the conversion pushes them into a higher IRMAA bracket. Conversely, your client could find that after the conversion is complete, their IRMAA fees are lower, as funds withdrawn from Roth accounts are not included in the income calculations for IRMAA. So it’s helpful to evaluate your client’s overall IRMAA payments with and without a conversion, as well as your client’s potential “IRMAA Drift.” This final evaluation can help your client decide if a conversion is right for them and, if so, what the conversion pattern should be.
Balancing Taxes, IRMAA, and Bracket Drift During a Conversion
As I mentioned at the start of this post, there are typically two decisions your client needs to make when considering a Roth Conversion:
First, should they convert? The answer to this question will depend on where they believe their taxes will be in the future versus today.
Second, how should they convert? Roth conversions often take place over several years to spread out the impact of taxable income to the saver during conversion. If your client decides a Roth conversion makes sense, they’ll need your help determining how to convert their funds in a way that minimizes taxes and government fees.
Why Your Clients Should Work with YOU
Most financial professionals today can help savers execute a Roth conversion. On top of that, Roth conversions are often a financial approach savers think they can do themselves.
But as we’ve shown above, the choice TO convert and the choice of HOW to convert can change based on tax burden, tax drift, and IRMAA.
If you have a client or prospect who’s working with another advisor or who thinks they can handle their conversion on their own, you can encourage them to consider the following questions:
Often, with these questions in mind, a client will see the value of working with an advisor who understands the complete analysis required to optimize a Roth conversion. After all, none of our clients want to pay more in taxes and government fees than necessary.