Roth IRA Conversions Can Be Appropriate for Federal Employees No Matter Their Age
Edward A. Zurndorfer
One of the most often asked questions made by individuals is how one’s age affects the decision to convert a traditional IRA to a Roth IRA. For federal employees, the question becomes: Is there any age in which an employee is too young to convert their traditional IRAs to Roth IRAs? How about those employees close to retirement? Is there any age in which an employee is too old to convert their traditional IRAs to Roth IRAs? How about after an employee retires from federal service? Does it make sense for a federal employee to convert their traditional IRAs to Roth IRAs after they retire from federal service?
A Roth IRA conversion can potentially be the right financial move at any age. But for most individuals including federal employees and retirees, an individual’s age will impact new employees, mid-career employees, employees within 5 to 10 years of retirement, and retirees when determining whether to proceed with a Roth IRA conversion strategy or not.
New Federal Employees – Newly Hired Employees Younger than Age 30
For federal employees who are newly hired and who are in their 20s or early 30s, Roth IRA conversions usually makes financial sense. This is because these employees are generally in a low federal marginal tax bracket (12 percent or 22 percent), have not accumulated large sums of money in their IRAs and Thrift Savings Plan (TSP), and “time is on their side”. As such, a conversion should not generate a huge tax bill, and once the Roth IRA conversion occurs, the Roth IRA may have decadesto potentially grow tax-free.
Any employee who converts a traditional IRA to a Roth IRA needs to be reminded of the tax consequences of a Roth IRA conversion and be prepared for the potential federal and state income taxes to be paid. They are advised to accumulate a sufficient amount of liquid savings (for example money deposited in a money market account or in a passbook savings account) in order to have the funds readily available without restriction in order to pay the federal (and state) income tax bill due as a result of performing a Roth IRA conversion.
If a young employee owns several traditional IRAs and is trying to decide which IRA is the most suitable to convert, the most suitable IRA to convert is most likely the IRA that has decreased in value the most over time. In selecting to convert that particular IRA, the tax bill due on converting that IRA should be less compared to converting a traditional IRA that has increased significantly in value over time. Many traditional IRAs that have been invested primarily in stocks have seen a downturn in their value year to-date during 2022, a result of the downturn in the stock market. Perhaps at this time it would be a good time to convert those traditional IRAs rather than selecting those traditional IRAs who have not changed much in value.
A word of caution is order with regard to Roth IRA conversions with respect to federal and state income tax withholding: Any traditional IRA owner under age 59.5 who plans to pay the taxes due on the conversion with dollars withheld from the traditional IRA at the time of conversion should reconsider the conversion. This is because the federal (and state) income taxes withheld are not converted. Therefore, the tax withheld will instead be considered an early withdrawal and subject to the 10 percent early withdrawal penalty.
Mid-Career Federal Employees – Employees with 10 to 20 Years of Service
For those federal employees in mid-career with 10 to 20 years of federal service, Roth IRA conversions can also make financial sense. But as will be explained, a Roth IRA conversion for a mid-career employee may require a more complicated analysis than for a new employee, with more issues to be considered.
Many tax professionals suggest that a Roth IRA conversion makes the most sense and appropriate for those individuals who in retirement will most likely be in higher overall marginal (federal and state) tax bracket. Those federal employees in mid-career earning good salaries, contributing each year to the traditional TSP, and who will retire from federal service with either a CSRS or a FERS annuity, sizeable TSP accounts, and a monthly Social Security retirement benefit will likely be in at least the same marginal tax bracket after they retire as they were when they were employees. If Congress raises individual tax rates (which could happen), mid-career federal employees could be in a higher overall marginal tax bracket after they retire and will then appreciate the tax-free withdrawals from their Roth IRAs.
While a Roth IRA conversion will likely raise the IRA owner’s tax liability in the year of conversion, once the converted traditional IRA are in the Roth IRA, the Roth IRA funds (including accumulated earnings) will be available to be withdrawn after age 59.5 tax-free. A Roth IRA conversion therefore eliminates the concern of possible higher tax rates in the future.
Another virtue of Roth IRAs is they are not subject to required minimum distributions (RMDs) during the Roth IRA owner’s lifetime. Eliminating future RMDs from traditional IRAs is another reason why mid-career employees may want to consider Roth IRA conversions.
For employees in mid-career, the timing of a Roth IRA is critical. Those mid-career employees are likely to be in the peak earning years and perhaps in the highest marginal tax brackets may want to thoroughly evaluate with their tax advisors any Roth IRA conversions. A Roth IRA conversion is generally recommended in a year when tax conditions are “optimum”. “Optimum” tax conditions include having available capital losses that will offset any capital gains, and perhaps having up to $3,000 of excess capital losses to offset ordinary income (wages, interest and other income).
Another consideration when converting a traditional IRA is the value of the IRA at the time of the conversion. In general, the higher the value of the traditional IRA, the more tax that has to be paid on its conversion. Therefore, it makes good sense to convert a traditional IRA that is down in value. In so doing, less tax will be paid compared to a higher valued traditional IRA.
Those mid-career employees who have college-age children may also want to consider the timing of a Roth IRA conversion. Any employee receiving college financial aid, based on income, may want to avoid an “income spike” resulting from Roth IRA conversions.
Federal Employees Within 10 Years of Retirement and Federal Retirees
Contrary to what some individuals and financial advisors may say and recommend, there is no age when an individual is considered too old with respect to performing a Roth IRA conversion. Older individuals may think they will not have enough time live in order to reap the benefits of a conversion. That may be true during the rest of the Roth IRA owner’s life, but it over looks the potential of using a Roth IRA conversion as an estate planning strategy.
Transfers of a portion of traditional TSP to a Roth IRA make sense for older federal employees (especially those employees between age 59.5 and 63 for Medicare Part B premium “income planning” purposes). For retired federal employees with sizeable CSRS or FERS annuities together with Social Security retirement benefits and who may not need all of their TSP accounts during their retirement (and who intend to pass on portions of their TSP accounts to beneficiaries) transfers of traditional TSP accounts to Roth IRAs also makes senses. This is relevant today after the elimination of the “stretch IRA” most adult beneficiaries under the SECURE Act. Most nonspousal beneficiaries will be subject to the 10-year rule which will compress the tax bill due on mandatory traditional TSP bequests to nonspousal beneficiaries into a shorter time period. The result is that after all taxes are paid on inherited traditional TSP assets, less will be left for the beneficiaries.
A Roth IRA conversion and/or a transfer of traditional TSP to a Roth IRA can eliminate any future tax bill for the Roth IRA beneficiaries. This is because income tax is paid at the time of conversion or transfer, possibly at lower tax rates thar apply currently. In that sense, a Roth IRA conversion or transfer of traditional TSP funds to a Roth IRA can be viewed as a tax-free gift to the next generation, almost like life insurance. Many older federal employees and federal retirees are not performing these Roth IRA conversions for their tax benefit but for their children’s, grandchildren’s and other beneficiaries’ future tax benefit
Another estate planning benefit of a Roth IRA conversion is the elimination of the need to take RMDs during the 10-year period, as would be required under IRS regulations when a traditional IRA owner dies on or after his or her required beginning date. This is because all Roth IRA owners are considered to have died before the required beginning date regardless of what age the Roth IRA owner dies. With an inherited Roth IRA, beneficiaries avoid the complication of having to calculate RMDs during the 10-year period following the death of the Roth IRA who performed the conversion. Also, inherited Roth IRA owners can retain the funds in the Roth IRA for the full 10 years following the death of the Roth IRA owner, thereby accruing tax-free earnings the full 10 years.
There are two areas of concerns that retired federal employees and in particular that retirees who have their required beginning date (RBD). The RBD is as follows: For those retirees born before July 1, 1949, the RBD is April 1 following the year they become age 70.5. For those retirees born after June 30, 1949, the RBD is April 1 following the year they become age 72. The first area of concern that with respect to Roth IRA conversions, no part of a traditional IRA required minimum distribution may be converted to a Roth IRA in any year. With respect to direct transfers of traditional IRAs to Roth IRAs in any year, no part of a TSP account that is part of a TSP RMD may be directly transferred to a Roth IRA. Only eligible rollover distributions” from a traditional IRA and/or TSP account may be converted or transferred respectively to a Roth IRA. In short, that means any traditional IRA and/or TSP RMD would have to be paid out first before a Roth IRA conversion and/or traditional TSP transfer to a Roth IRA is performed. This will increase taxable income for the year and therefore may reduce the amount that a federal retiree subject to RMDs would want to convert and/or transfer to a Roth IRA.
The other concern for federal retirees is that a Roth IRA conversion and/or traditional TSP transfer to a Roth IRA does increase ordinary income in the year of conversion and transfer. This increase of ordinary income could potentially cause the loss of some tax credits and tax deductions, the possibility that a federal retiree may be subject to the net investment income tax (NIIT), and increased monthly premiums for Medicare Part B (Medical Insurance). Note, however, that the additional income is perhaps for only one year, and the trade-off is tax-free earnings over time together with tax-free distribution for the converted Roth IRA owner and beneficiaries.
As explained and illustrated, the issue of the appropriateness of Roth IRA conversions and transfers of traditional TSP to a Roth IRA is complex and very individualized. Those employees who are considering a program of Roth IRA conversions and/or traditional TSP transfers to Roth IRAs are strongly encouraged to speak with their financial advisors and tax accountants before embarking in Roth IRA conversions and traditional TSP transfers to Roth IRAs. In so doing, they will hopefully make sure that the program is financially appropriate to them and to their families.
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.
