A flurry of Roth IRA conversions occurred in 2010 when income ceilings were first removed, allowing anyone to shift traditional IRA dollars into the Roth format. Although publicity about the Roth conversion opportunity has quieted down since then, the potential tax benefit, under the right circumstances, remains just as great today.

"I believe many taxpayers who could benefit from this tax diversification strategy are not aware that it exists," said Andy Watts, CFP, manager of Wealth Management Support at HD Vest Financial Services. "CPA and tax professionals can deepen their client relationships and provide a valuable service by helping them to determine whether a Roth conversion makes sense."

The advantage of the Roth IRA, of course, is that although only after-tax dollars can be contributed, all qualified withdrawals from the account are tax-free - both principal and earnings.

Some key variables that need to be weighed in determining the appropriateness of a Roth conversion, according to Watts:

  • Time horizon: The longer the period until the funds will be needed to provide retirement income, the more attractive a Roth conversion might be. That's because the ultimate ratio of total after-tax principal contributions to tax-free earnings accruing in the Roth will be smaller than it would be if the conversion occurs closer to retirement.
  • Tax status of traditional IRA contributions already made: The tax liability triggered by a conversion from a traditional IRA to a Roth varies according to the proportion of pre-tax to after-tax (non-deductible) contributions in all the taxpayer's IRAs (traditionals, SEPs, SIMPLEs). If a high proportion of contributions were made with after-tax dollars, the lower the tax hit at the time of a Roth conversion.
  • Availability of cash to cover the tax bill: All amounts not previously taxed (i.e., everything other than after-tax contribution amounts) will be taxed as ordinary income. If the taxpayer lacks sufficient cash outside of the IRA account to pay taxes, a conversion might not make sense. Any funds taken from the IRA (or, for that matter, a tax-deferred account) to pay the tax bill would be taxable and, if the taxpayer is younger than 59-1/2, be subject to the 10 percent early withdrawal penalty.
  • Income recognition timing flexibility: If a client finds themselves in an unusually low tax bracket, the timing may be appropriate to consider a Roth conversion, assuming they have adequate cash reserves in a taxable account to cover the tax liability.
  • Expectations of future tax rates: A fundamental rationale for tax deferral is the expectation of facing lower tax rates when funds become taxable. If you believe there is a reasonable likelihood that a client will face a higher tax bracket at retirement, a Roth conversion could be beneficial. Better to take the tax hit now at the lower rate.

While predicting tax rates decades into the future is probably impossible, allowing clients to achieve greater tax diversification by, in effect, locking in today's tax rates for a portion of their future retirement income, can be a prudent move.
For more on Roth IRAs, see our 60 Seconds Smarter video, under the Tax Alpha tab on AccountingToday.com.

Published in partnership with HD Vest.

For more information about HD Vest Financial Services and how they can help you transfer a client’s wealth, visit hdvest.com/taxalpha6 or contact a Business Development Consultant at (800) 742-7950.

HD Vest Financial Services® and its affiliates (collectively, “H.D. Vest, Inc.”) do not provide tax or accounting services. You should consult your tax professional regarding the tax implications of any investments.

The views and opinions presented in this article are those of Chad Smith and not of HD Vest Financial Services® or its subsidiaries.

HD Vest Financial Services® is the holding company for the group of companies providing financial services under the HD Vest name.
Securities offered through HD Vest Investment ServicesSM, Member SIPC, Advisory services offered through
HD Vest Advisory ServicesSM, 6333 N. State Highway 161, Fourth Floor, Irving, TX 75038, 972-870-6000.

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