What you need to know about Roth IRA conversions in 2018
In: Retirement Planning

I guess it was only a matter of time before we needed to talk again about Roth conversions. 2018 has brought more than a few changes, and here at  Milestone Wealth Management I have been busy helping individuals and couples decide whether or not a Roth conversion is right for them.

Scott and Aubrey, for example, were just in my office for those very reasons. They are both in their early 50s and have really ramped up contributions to their retirement savings plans and have accumulated quite a bit in their Traditional IRA’s over the last several years.

Because Scott and Aubrey are high earners – him being a sales manager and her an engineer – they had a lot of questions about the Tax Cut and Jobs Act and what it might mean for their retirement strategy:

“With these lower incomes taxes, would it make sense for us convert to a Roth IRA?”

For folks like Scott and Aubrey, that’s one of the big questions of 2018. And after evaluating their unique circumstances, we found that doing a partial Roth conversion this year, did make a lot of sense for them.

But keep this in mind: a Roth conversion will not make sense for every high-earning couple in their 50s. I know that a lot of financial blowhards like to generate buzz by throwing out very specific scenarios as if they were guaranteed one-size-fits-all solutions.

Folks, that isn’t how things work. In fact, it’s just downright dangerous to your financial health to believe it does. If there is anything I have learned for certain, it is that every situation is different, regardless of how similar they may appear on the surface.

So, before we go any further on this topic, let’s brush up on the basics…

What are the advantages of a Roth conversion?

Well, it all comes down to the differences between a Traditional IRA and the Roth IRA. As you probably know, the Traditional IRA is funded with pre-tax dollars. This allows your funds to grow tax-deferred until you begin taking distributions.

A Roth IRA, on the other hand, is funded with dollars already taxed as income. This means that when you reach eligibility for distributions, you pay no federal taxes on this income. With income taxes having been reduced for 2018, the idea of taking care of those taxes now, as opposed to later when they might increase, does look appealing.

And for many, this could be a huge advantage.

And unlike the Traditional IRA, the Roth does not require that you take distributions at age 70½. In other words, if you have multiple retirement assets, like Scott and Aubrey, the Roth provides more freedom in managing your retirement income.

Does a Roth conversion make sense in 2018?

Before we get into whether or not a Roth conversion makes sense, it is important to reiterate here that no two individuals will ever have identical retirement savings needs. It’s for this reason that I always tell people to never act on general advice until they’ve spoken with a trusted and qualified retirement specialist who will analyze their unique situation.

So, bear that in mind as we discuss the following.

With the Tax Cut and Jobs Act reducing the tax burden for millions of Americans, I have met several people who believe a Traditional IRA makes more sense for retirement. And it very well may. After all, if taxes remain lower, that is less you will owe the federal government when taking distributions.

That’s a pretty big IF, though. I mean, we have no way of knowing for certain, but historically tax rates are actually quite low. And eventually, the government is going to have no choice but to address that $21 trillion national debt. That could very well mean an across-the-board increase in income taxes at some point in the future.

If that were to happen, tax-free distributions from a Roth IRA would probably look a whole lot better than a Traditional IRA funded with pre-tax dollars. So, a Roth conversion does appear to make more sense from this perspective. Again, however, this would depend on the circumstances of your unique situation.

On the other hand, here are a few points that might put you at a disadvantage when converting to a Roth in 2018.

First, if you are already enrolled in Medicare or are planning to enroll soon, a Roth conversion could throw you into a higher income bracket, which might result in more expensive Medicare premiums for the year.

In this case, you may want to consider an incremental approach to the Roth conversion. In other words, spread the distributions out over a longer period of time to prevent skewing your income tax bracket.

On the other hand, withdrawals from a Roth IRA do not increase taxes on your Social Security benefits. If withdrawals from a Traditional IRA is needed to provide a significant portion of your retirement income, up to 85% of your Social Security benefits could be subject to income taxes. So, it is just as important to diversify your taxes as it is to diversify your investment portfolio.

Secondly, if you are going to need access to the Roth IRA funds soon, a conversion might prove a problem. Federal law requires that 5 years pass from the tax year you first funded your Roth before you can take a distribution. Otherwise, there could be steep penalties.

Finally, there is always the chance this amazing market we are having could experience a hiccup. While I feel good about current trends, the truth is that even the very best analysts cannot account for every variable that influences markets. Things happen, markets fluctuate.

Why is this a problem for a Roth conversion? Well, the federal government had allowed “Roth conversion do-overs” in the past.

Let’s say you convert $100,000 and then, over the next few months, the markets take a hit. Sure, the markets will most likely correct and eventually perform better than before – speaking from history, that is – but if your $100,000 is suddenly worth $75,000 at the end of 2018, the federal government doesn’t really care about your loss. You will be required to pay taxes on the full $100,000 rolled over.

A do-over had allowed you to effectively cancel the rollover to avoid situations like that. But the Tax Cut and Jobs Act has eliminated the Roth conversion do-over.

Qualifying for a Roth IRA in 2018

The great news is that more people may qualify to make contributions to a Roth IRA in 2018. Last year, contributions were limited to single filers earning less than $133,000 or less, or $196,000 per year for married couples filing jointly.

For 2018, however, you may contribute to a Roth IRA if you earn less than $135,000 as a single filer, or $199,000 filing jointly as a married couple.

While this may not be a huge increase in modified adjusted gross income (MAGI), it does mean more Americans can take advantage of the Roth IRA.

So, let’s take a look at specifics…

 

Filing StatusMAGI LimitContribution Limit
Married filing jointlyUp to $188,999$5,500
Married filing jointly$189,000 – $198,999Begins to phase out
Married filing jointly$199,000 or moreCannot make direct contributions to a Roth IRA
Married filing separately$0$5,500
Married filing separately$1 – $9,999Begins to phase out
Married filing separately$10,000 or moreCannot make direct contributions to a Roth IRA
Single filerUp to $119,999$5,500*
Single filer$120,000 – $134,999Begins to phase out
Single filer$135,000 or moreCannot make direct contributions to a Roth IRA

 

Okay. There are some exceptions to this table, and there are probably a few things needing a better explanation.

For example, if you are age 50 or older, your maximum annual contributions are raised from $5,500 to $6,500. This rule allows older investors to play catch-up on their retirement savings.

Another exception is when married filing separately. If you haven’t lived with your spouse in the past year, you can actually use single filer rules when making contributions to a Roth IRA.

And what am I talking about, exactly, when I say “begins to phase out?” During this phase out period the amount that you can contribute to a Roth IRA is reduced based upon where your income falls within these phase out ranges.

All of this being said, we should clarify one crucial point here…

Know also that you may be able to still contribute to an Traditional IRA even if you make too much to contribute to a Roth IRA.  You could then almost immediately convert it to a Roth IRA. I refer to this as a “backdoor Roth IRA.”

Know that this gets tricky though if you have other IRA accounts so makes sure to speak with a retirement planning professional before even considering doing this.

Making your next move

We’ve covered the basics here. But there are so many other points to consider, that we could not possibly cover them all in a single article.

Again, this is why I urge you to consult with a qualified retirement professional, especially one with a lot of experience helping people navigate the options based on their retirement needs and unique situations.

Not only that, but there are many rules involved in the rollover and in the conversion process. Doing it on your own leaves a lot of room for costly oversights.

So, don’t do it alone.

We here at Milestone Wealth Management have advised and managed Roth conversions for many individuals and married couples. Give us a call at 714-462-9155. We would be happy to meet with you, help to evaluate your situation, and offer our experience and expertise.