By Pete Hunt, CFP®, CTFA, Director of Client Services
During the first half of 2022, the market dipped to record lows while inflation peaked to its highest level since 1981. In response, the Federal Reserve vowed to combat these issues through a series of interest rate hikes.1 As we enter the latter half of the year, many investors believe the market may have bottomed out.
Given the current levels of government spending and increasing debt, higher income tax brackets are a real possibility for the future. Roth IRA conversions are typically considered at the end of the year once all income is known, but today’s environment may provide a significant opportunity for those considering the tax advantages of this strategy.
A Roth conversion moves at least a portion of a traditional IRA into a Roth IRA with the goal of tax-free future growth and withdrawals. Although it warrants higher taxes now, it may result in a smaller tax bill later. Below, we’ve identified a few of the many areas of opportunity for effective Roth conversions.
Clients in a lower tax bracket now than they may be after starting RMDs:
Taxpayers tend to fall in the middle of brackets. Roth conversions can be used to maximize current marginal tax rates and allow funds to grow tax-free with minimal risk. To determine whether this is the best option, advisors look for a sweet spot in their client’s current and anticipated income and tax bracket.
In 2017, The Tax Cuts and Job Act (TCJA) was enacted, resulting in significant changes for individual filers and corporations. The bill lowered most individual income tax rates, however, in 2025, when it expires, it’s very likely rates will increase.2 Although this increase will not pose a risk to most tax planning strategies, the overall benefits of Roth conversions are still compelling.
The 2019 Setting Every Community Up for Retirement Enhancement Act of 2019 (SECURE Act) requires retirees who reach age 70½ in 2020 or later to take their first Required Minimum Distribution (RMD) by April 1 of the year after turning 72.3 Retirees in their early 60s who are not yet mandated to start RMDs can use a Roth conversion to reduce or eliminate them once required. While this group makes ideal candidates for a conversion, it is important to be mindful of Medicare premiums for those age 63 and older, as they can alter taxable income enough to prompt an income-adjusted surcharge. This year, the standard Part B premium amount in 2022 is $170.10.4
Investors with a large percentage of assets in pre-tax IRAs:
Traditional IRAs and 401(k)s are highly susceptible to tax rate hikes. To illustrate this point, consider the role of the IRS in IRAs. Investors own their IRA with the IRS, which determines the percentage of the partnership. Clients in a high tax bracket now are likely the most susceptible to increases in the future, and a Roth conversion can be used to mitigate that risk.
If the market is truly bottoming out, this provides investors an opportune time to utilize this strategy. While Roth conversions are an attractive option for many clients, they are not for everyone. If you have any questions, please contact your Exencial advisor.
Exencial Wealth Advisors is an SEC-registered investment adviser. Any reference to the terms “registered investment adviser” or “registered” do not imply that Exencial or any person associated with Exencial has achieved a certain level of skill or training.