Ed breaks down for whom this month may be the best time to perform a Roth Conversion in their Individual retirement account.
Edward A. Zurndorfer–
Conversions of traditional IRAs to Roth IRAs can be performed at any time. Federal employees aged 59.5 and over and federal employees who have retired from federal service are allowed to transfer traditional TSP funds directly to Roth IRAs. With much talk in Washington about raising individual tax rates in the near future, this last month of 2021 may be an ideal time for traditional IRA owners and traditional TSP participants to start performing Roth IRA conversion and transferring their traditional TSP accounts to Roth IRAs.
Roth IRA conversions and a transfer of traditional TSP funds to a Roth IRA are taxable events. Either event make will make financial sense if individual tax rates are expected to increase in the future. This is because the cost will be more in terms of additional taxes that would have to be paid on the conversion or transfer, a result of higher individual tax rates.
Federal employees and annuitants interested in performing Roth IRA conversions and/or traditional TSP transfers to Roth IRAs during December are encouraged to first do a calculation of their anticipated 2021 federal and state tax liabilities in order to determine how a traditional IRA conversion to a Roth IRA and/or transfer of traditional TSP funds to a Roth IRA would impact their 2021 tax liabilities. They want to make sure that as a result of a Roth IRA conversion or traditional TSP transfer, that they do not end up in a higher marginal tax bracket for 2021. They should work with a knowledgeable financial and tax advisor in order to make sure that they: (1) convert or transfer the optimum amount of traditional accounts to Roth IRAs so as to not push them into overall (federal and state) marginal tax bracket for 2021 and determine what the resulting tax liabilities will be; and (2) can afford a conversion or transfer or traditional TSP funds in the sense that they have sufficient “liquid” assets (such as passbook savings or money market funds) to pay the federal and state income taxes due resulting from the conversions or transfers.
No More Roth IRA Conversion “Do-Overs”
Since the passage of the Tax Cut and Jobs Act of 2017 (TCJA), Roth IRA conversions are permanent – the conversions cannot be “undone” as they could pre-TCJA. It is therefore important for employees planning a conversion of a traditional IRA to a Roth IRA to make sure they are fully aware of what the total tax cost will be. Employees should also be aware that they will need to have “liquid” funds available to pay the federal and state income due on conversions performed in December 2021. Employees will have to make estimated tax payments (federal and state) on any conversions performed in December. This is because, given the limited amount of time to change their federal and state income withholding with less than a month left in 2021, it is best that these individuals pay any taxes due on conversions via estimated tax payments. The last estimated tax payment for2021 is due January 18, 2022.
Most employees should have a good estimate of what their 2021 marginal tax bracket will be since most of their income will be known by the middle of December. Although some employees may feel that their 2021 marginal tax bracket seems high, delaying conversions could cost them more in future years, based on the assumption that individual tax rates are likely to increase in the near future.
The ideal Roth conversion planning strategy is to convert when income tax rates are lower – which for many middle-to-upper income individuals is at the current time. Another reason is that If conversions are delayed, then the traditional IRA and/or traditional TSP accounts will grow over time, and as the traditional balances grow over time, the more taxes will have to be paid in taxes when these accounts are converted in future years because of the higher account balances.
While Roth IRA conversions and traditional TSP transfers to Roth IRAs performed at the current time are a gamble in the sense that income tax rates will be increasing in the future, it is certainly a risk that employees can and should plan for. But employees need to consider that the more the converted Roth accounts grow over time, the greater the odds of “winning the gamble.” This is because not performing Roth IRA conversions traditional TSP transfers currently will mean that traditional IRA and traditional TSP accounts will continue growing tax-deferred over time. Larger future traditional IRA and traditional TSP account balances will result in larger future required minimum distributions (RMDs) when the traditional IRA owner and traditional TSP participant reaches their required beginning date to start their RMDs.
Perform Roth Conversions Before Required Beginning Date in Order to Decrease Traditional IRA Balances
Those employees who are years away from their required beginning date – when they must start taking required minimum distributions from their traditional TSP and traditional IRAs – are ideal candidates to perform Roth IRA conversions. For example, individuals in their late- 50’s or early 60’s are good conversion candidates because they have more years to perform smaller IRA Roth conversions and traditional TSP transfers in order to minimize their federal and state tax liabilities.
Perform Roth Conversions Before Medicare Income – Related Monthly Adjustment Amounts Take Effect
Individuals enroll in Medicare Part A (hospital insurance) and Medicare Part B (medical insurance) usually at age 65. They pay no monthly premium for Part A, but they pay a monthly premium for Medicare Part B. The higher a Medicare Part B recipient’s adjusted gross income (AGI), the higher the recipient’s Part B monthly premium.
Part B monthly premiums can change from year to year as one’s AGI changes from year to year. This is called Medicare’s income-related monthly adjustment amount (IRMAA).
IRMAAs are somewhat of a challenge to estimate for two reasons. First, these charges do not appear on tax returns as a tax. They are charged and paid separately. Second, IRMAA charges have a two-year look-back provision. This means that Roth conversions performed during 2021, and therefore adding income for 2021, will not trigger IRMAA additional charges until 2023.
Large Roth conversions can definitely be one of the big income items that cause increases in IRMAA charges. These increases work on a “cliff” basis, which means that going over $1 into a higher Medicare Part B income tier will result in additional IRMAA charges, sometimes increasing charges by hundreds of dollars. The advice is for individuals younger than age 63 and to seriously consider Roth IRA conversions. This is because once an individual reaches age 63, given the two-year AGI “look-back” provision, IRMAA charges will be affected as a result of Roth IRA conversions and traditional TSP transfers to Roth IRAs.
There is another situation in which performing a Roth IRA conversion during this last month of December may be an optimum time. That involves the situation of a married couple in which one spouse died sometime during 2021. This is because the year 2021 may be the last year the surviving spouse will be able to take advantage of lower married filing jointly tax return rates. By performing Roth IRA conversions before the end of December, the surviving spouse will likely pay a lower tax on the conversion compared to what they would pay if the conversion were to be performed during 2022 when the surviving spouse will be filing his or her tax return as single.
Finally, employees and retirees should be aware that unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period. Converting a traditional IRA into a Roth IRA has tax implications.
Roth IRA Conversion
Edward A. Zurndorfer is a CERTIFIED FINANCIAL PLANNER™ professional, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.