Lawmakers have diluted a retirement tax break popular among wealthy Americans, leading many to consider a strategy known as a Roth conversion for individual retirement accounts to try softening the blow.
A Roth conversion involves the owner of a traditional IRA, which is funded with pretax contributions, moving that money into an after-tax Roth IRA. Account holders must pay the associated income tax on the balance converted but benefit from tax-free withdrawals later.
The move could save families tax money over the long run, given new rules around some IRA withdrawals, according to financial experts. Yet taxpayers could inadvertently overdo it and hurt their finances in the long term, they warn.
"There's certainly an argument to be made that Roth conversions should go up for certain individuals," said Jeffrey Levine, CEO and director of financial planning at Blueprint Wealth Alliance, based in Garden City, New York. "There's no question about that. The question is, to what extent?"
The Secure Act, signed into law last month by President Donald Trump, reined in rules around the so-called "stretch IRA." The rules apply to retirement accounts inherited after the death of someone such as a parent or grandparent.
Prior law allowed heirs to "stretch" the required minimum annual withdrawals from these accounts over their lifetimes. The regulations provided a useful estate-planning technique for wealthy families, since heirs of large IRAs could get decades of tax-free investment growth.
However, new rules require heirs to deplete the accounts within 10 years of the owner's death — a much shorter time frame.
That compressed time window will generally mean larger annual withdrawals — and larger associated tax bills — for heirs. (The new rules don't apply to some beneficiaries, like a surviving spouse, minor child, disabled or chronically ill individuals, or anyone within 10 years of age of the deceased account holder.)
Many IRA owners are considering Roth conversions to spare their descendants a big tax hit in the future. Roth accounts must also be depleted over a decade, but heirs wouldn't owe any income tax on the distributions.
However, some experts warn too many conversions could have the unintended effect of triggering a higher tax bill over time.
"Deeply concerned that elimination of stretch will lead to OVER-conversion of IRAs and diminish long-term wealth," tweeted Michael Kitces, partner and director of wealth management at Pinnacle Advisory Group, based in Columbia, Maryland.
Generally, the best candidates to do a Roth conversion expect to leave a large account to one or only a few beneficiaries, want to mitigate the heir's tax burden and have enough money on hand to pay the conversion tax.
A $500,000 pretax IRA left to six children likely wouldn't yield a big tax hit to those heirs, but it's a different story for one child inheriting a $1.5 million account, for example.
The strategy is also generally better for those who anticipate being in a lower tax bracket (both state and federal) than their heirs.
That said, all but the wealthiest taxpayers probably shouldn't convert their entire account to a Roth, said Robert Keebler, CPA and partner with Keebler & Associates, based in Green Bay, Wisconsin.
"I'm probably adverse to doing a complete Roth conversion for most middle-class people," Keebler said.
Being diversified among pre- and after-tax accounts is important for many savers, said Ed Slott, CPA and founder of Ed Slott & Co. in Rockville Centre, New York.
For example, it may make sense for charitably inclined individuals to keep some money in a traditional IRA, Slott said.
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These taxpayers can use a qualified charitable distribution after age 70½ to give to charity from a traditional IRA at no tax cost, he said. Taxpayers 72 years and older can also use a QCD to satisfy part or all of their required minimum distribution for the year.
Those who itemize big medical expenses on their tax returns can also benefit from having traditional-IRA money on hand, Slott said. That's because those deductions — which could sometimes extend to more than $100,000 — could lower taxes by offsetting income drawn from a pretax retirement account.
The most prudent way to do a Roth conversion is generally converting a little bit each year instead of a large chunk at one time, according to financial experts.
Aim to "fill up" tax brackets with the conversions. For example, a married couple filing jointly falls in the 24% tax bracket with income up to $326,600 this year. A couple with $300,000 of income could safely convert $20,000 of pretax money to Roth and stay in the 24% bracket.
Taxpayers should do conversions toward the end of the year, perhaps after Thanksgiving, when they have a better sense of their total income, including bonuses and capital gains.