4. Side Effects Of Roth Conversions—Stealth Taxes
A Roth conversion increases a person’s adjusted gross income, which in turn may trigger other “stealth taxes.” These are additions to the tax bill that come from losing tax deductions, credits or other benefits tied to AGI. For example, medical deductions, child tax credits, the taxation of Social Security benefits or even the potential loss of the new 20% deduction for qualified business income (the Section 199A deduction). Increased income can increase Medicare premiums too, or impact financial aid eligibility.
While these might be reasons to avoid a Roth conversion, they are only short-term blips in tax planning, because the additional taxes would only be for the year of the conversion. But if this bothers your clients, I would explain to them that they have to look at the bigger picture: that is, the long-term benefit of the Roth IRA. The tax cost is a one-time, short-term expense to gain a greater benefit throughout retirement.
5. Financial Aid
Financial aid may be affected by a spike in income from a Roth conversion, so timing here is critical, especially when a large chunk of needed money might be at risk. While retirement accounts are generally excluded for financial aid, income is not. For clients who need the aid and could suffer from a spike in income, a Roth conversion may have to be put on hold until assistance is no longer needed.
6. Money Is Needed Sooner, Not Later
If the client will need to access the Roth funds sooner rather than later, that’s a vote against a Roth conversion. The tax cost may not be worth the benefit if the funds are not given time to grow. One good tell: If the clients are asking how soon the Roth funds can be accessed, then they are not good candidates for a conversion. The big Roth benefit is in the tax-free compounding of the money in the account over time. Roth conversions are not for getting money to use in the near term.
7. Where Does The Conversion Money Come From?
Even if clients want to convert, they’ll need to know for sure that the money will be there to pay the tax bill. Again, under the new law, there’s no going back. The conversion is permanent. The taxes will be owed. If the only funds available to pay the tax bill are in the IRA itself, then the clients shouldn’t do the conversion. That would immediately diminish the amount converted. Besides that, any IRA funds used to pay the tax would not only be taxable but also subject to the 10% early distribution penalty if the client were under age 59 1/2 (and there were no exceptions applied).
8. Over 701/2 And Subject To RMDs