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Roth IRA Conversions Over the Years – Part 2, the “Con Side”


Last week we explored some history regarding the transaction known as a “Roth IRA Conversion,” whereby funds in tax-deferred, or Qualified, Retirement Accounts can be converted to a tax-free Roth IRA. Later on, withdrawals from the Roth IRA would not only be tax-free, but they would be voluntary during the owner’s entire life. These are powerful incentives for some people, and many taxpayers annually participate in the Roth Conversion process.

The downside is that Roth IRA Conversions are 100% taxable as ordinary income in the year of the Conversion, so the costs and benefits have to be carefully weighed before making a good financial decision.

For several years, Congress continued to make changes in the Tax Code favoring Roth conversions. Elimination of income limits for making Roth Conversions increased their availability. Reducing income tax rates in 2018 provided further financial incentives. Lately, however, Congressional changes are clouding the benefits of Roth IRA Conversions.

Strangely, the new rules were not implemented with an eye toward reducing Roth IRA Conversions, with one exception. The Tax Cuts and Jobs Act of 2017 (TCJA) eliminated the process of Recharacterizing (essentially undoing) a Roth IRA Conversion in the following year. Ending this provision reduced the tax predictability of making the Conversion in the first place, and has severely limited Roth IRA Conversions as a Financial Planning tool.

Other recent changes further decreased the functionality of Roth IRA Conversions for many taxpayers. In response to the COVID-19 pandemic of 2020, Congress passed the CARES Act and the SECURE Act. Under these laws, all Required Minimum Distributions (RMDs) were suspended for the year 2020, and the Required Beginning Date (RBD) for RMDs was raised from 70-1/2 to 72 for taxpayers born after June 30, 1949. Proposals currently before Congress would further raise the RBD from 72 to 75 for the same population. The most prominent of these proposals is dubbed SECURE Act 2.0. If this passes, we will report the change immediately.

Also, Congress introduced a change to the Life Expectancy Tables used to determine the amount of the RMD. Americans are living longer, and the changes reflect an increase in average life span. The new tables will reduce all future RMDs. IRS accepted the changes, but they were proposed too late for 2021, and will not be effective until 2022.

Delayed and reduced RMDs diminish the current economic value of paying current taxes on Roth IRA Conversions. Savings from a Roth IRA Conversion in 2020 will not begin to have a positive financial effect until later in life.

One further disincentive for making Roth IRA Conversions was elimination of the “Stretch” provision for most beneficiaries, part of the recent SECURE Act. No longer can a Roth IRA be inherited and “Stretched” over the lifetime of the inheritor. In place of the “Stretch” provision, Inherited IRAs today must be emptied out within 10 years, but there are no RMDs during that period. Many people were unaware that all Inherited IRAs, including Roths, were required to start RMDs in the year after death of the original owner. Over time, those RMDs were also larger than from a non-inherited IRA, as a separate formula was used for each annual withdrawal. All withdrawals from a Roth IRA remain tax-free.

Whatever your opinion regarding loss of the “Stretch” provision, today’s rules are, to me at least, less conducive to the Roth Conversion.

Further contributing to the declining value of Roth Conversions are changes to the Qualified Longevity Annuity Contract, or QLAC, which provide the account owner with a method of deferring partial RMDs for one or more years. Under the proposed SECURE Act 2.0, the maximum QLAC would be raised from $125,000 to $200,000.

No financial planning tool is suitable to everyone, but a qualified CFP® has answers for particular problems, and the training to apply available tools to your personal situations.

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