The case for Roth IRA conversions for high-income clients

High-income clients have tax challenges. They want advisers to find ways to lower their income taxes. Roth IRAs are tax-free accounts, so that should make a perfect marriage. Yet many advisers find high-income clients are reluctant about doing Roth conversions. There are no income limitations for Roth conversions, as there are for Roth IRA contributions, but conversions trigger an upfront tax bill. Clients in higher tax brackets may be particularly hesitant to write large checks to the IRS many years before it’s absolutely necessary.

Indeed, the total tax bill can be steep. Once state income tax, local income tax, the 3.8% net investment income surtax, income-based phaseouts of various tax benefits, taxation of Social Security income and exposure to higher Medicare Part B or D premiums have been considered, the effective tax rate might be 40% or even 50% of the conversion amount.

For an adviser, telling a client with a $500,000 traditional IRA that there’s a great tax planning idea that will cost $250,000 up front may generate understandable resistance.

Still, Roth IRAs can make sense for some high-income clients. Paying tax now, on today’s balance, may be preferable to paying future tax on a much larger sum, year after year, when distributions are required at age 70½.

Example: Jim is in the top tax bracket and likely will continue to be there. At some point, the money in his traditional IRA will be forced out each year in required minimum distributions and be heavily taxed for life. Say Jim is currently 53 years old with $500,000 in his IRA. Assuming Jim earns an annualized 8% inside his IRA, that $500,000 will grow to around $2 million by the time he must begin RMDs at age 70½.

On that $1.5 million of growth, the government could be a 50% partner. Jim might prefer to pay the $250,000 in tax — which he would have to pay, in any case — now and avoid any tax on the possible $1.5 million of future retirement account growth.

What’s more, there’s no guarantee that Jim’s effective tax rate would remain at 50% for the next two decades when RMDs commence. Recent tax legislation has focused on targeting high earners, and that may continue to be the case. States may hike their taxes, too. Any federal or state tax increases likely will be imposed on Jim, as he takes RMDs from his traditional IRA.

Under current law, Jim’s distributions can be tax free after a conversion to a Roth IRA, as long as he passes the five-year and age 59½ tests. That would be true even if future tax legislation pushes up effective tax rates to much higher levels. What could be better than locking in a 0% tax rate on any distributions Jim chooses to take from his Roth IRA?

Many high-income clients are high-net-worth individuals, with gift and estate tax concerns. For such clients, Roth IRA conversions can offer additional benefits.

Research indicates that high-income taxpayers tend to have high-income offspring. If high-bracket beneficiaries must take traditional IRA withdrawals, they’ll owe steep taxes; an inherited Roth IRA, on the other hand, can deliver a tax-free legacy — one that can be provided without triggering any gift tax.

In our example, Jim may be able to convert his $500,000 traditional IRA to a Roth IRA, paying $250,000 in tax. Jim, now 53, might die at age 89, with an $8 million Roth IRA. Roth IRA owners have no RMDs, so Jim can keep the account intact for his children, if he wishes, and the assumed 8% growth rate can continue.

At this point, Jim’s $8 million Roth IRA can pass to his son and daughter, both in their 50s, typically some of the peak earning (and income tax paying) years. The Roth IRA beneficiaries will have RMDs but they won’t owe income tax on hundreds of thousands of dollars in withdrawals each year.

A high-income client who pays tax owed by someone else may be subject to gift tax. That won’t be the case with a Roth IRA conversion, even though today’s tax payment will eventually spare the beneficiaries from paying tax on distributions they are required to take.

In Jim’s case, from an income tax point of view, leaving his children an $8 million dollar Roth IRA could be roughly equivalent to leaving them an $8 million IRA plus a $4 million “regular,” non-IRA account that could be used to cover the taxes.

Financial logic may not overcome stiff resistance from clients. Even high-income clients might balk at writing big checks to the IRS now in return for potential future benefits. But another way to look at a Roth IRA conversion is as tax insurance. High-income clients probably hold life insurance, disability insurance, property insurance, liability insurance and so on. The tax paid on a Roth IRA conversion can be likened to the premium paid for tax insurance. With a Roth IRA, the client will no longer have to worry about the effect or uncertainty of future tax rates on their retirement income.


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