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The 3 Most Misunderstood Tax Effects of a Roth Conversion

We’ve written extensively about the benefits of the Roth IRA. The Roth IRA is one of the most powerful tools available for creating tax-free income in retirement. Not only do Roth IRAs provide tax-free growth and tax-fee withdrawals in retirement, they also provide greater flexibility by empowering retirees to avoid the required minimum distributions that drive up the cost of Medicare and reduce the cash-flow that is available to support your lifestyle when you stop working.

While the Roth IRA is one of the tools that we use to help our clients plan for a meaningful and peace-filled retirement, we are going to address the three most misunderstood tax effects of Roth conversions. While any advisor can suggest a Roth conversion to save on future taxes, we are sharing the potential downside of Roth conversions with you today, as these drawbacks that may not be considered can cost you.

The 3 most misunderstood tax effects of a Roth conversion:

1. The impact on Long-Term Capital Gains Tax

2. The impact on Medicare premiums

3. The impact of non-deductible contributions on the conversion tax

Bonus: The impact on the Qualified Business Income Deduction for small business owners

Capital Gains

Let’s take an overly-simplified example of a retired 62-year-old married couple filing a joint return. They have not applied for social security. They are living off their taxable investment account, and they are strategically selling portions of this account each year to fund their living needs. They need about $16,000 per month to fund their lifestyle, so they sold $200,000 of their investments this year. In selling the $200,000 from their taxable account, they created $100,000 of long-term capital gains on the sale of these investments.

Due to the large standard deduction and the tax rules on long-term capital gains, the $100,000 of taxable income that they generated will create ZERO tax liability for this couple. They accessed $200,000 of liquidity from their taxable investment portfolio and they will pay ZERO dollars in tax this year.

Now we are going to add in a $120,000 Roth conversion before year-end. In creating an additional $120,000 of taxable income for this couple, we are squeezing out the $100,000 of long-term capital gains income that was tax-free. Not only will this couple owe the tax due on the $120,000 of Roth conversion income, but they will now also owe $15,000 on the long-term capital gains that was not taxable prior to the Roth conversion.

The important point here is that the tax on the Roth conversion was much greater than the Roth conversion, because it created additional income tax on income that was not taxable prior to the conversion.

Medicare Premiums

The Income Related Monthly Adjustment Amount (IRMAA) drives the cost of Medicare premiums paid by Medicare recipients.

Today’s Medicare premiums are based on the income tax return filed two years ago. That means that the impact of the income created by Roth conversions in 2022 will not be fully evident until the Medicare premiums come forward in 2024.

The take-away: It’s critical to have someone in your corner who has a comprehensive understand of the long-term impact of the Roth conversion. When doing Roth conversions after the age of 65, it’s not just the additional income tax that needs to be accounted for, it’s the additional Medicare premiums that will be due two years down the line.

The impact of non-deductible contributions

When converting IRAs from a traditional IRA to a Roth IRA, the conversion may include a portion of after-tax funds and pre-tax funds. If you’ve ever made a non-deductible contribution to your IRA or your 401(k), then you have funds that can be converted to a Roth IRA without a tax bill.

For example: if you have $100,000 in your IRA, and you’ve made $20,000 of non-deductible contributions to your IRA, then only 80% of your Roth conversion is taxable. The most common misconception around non-deductible contributions is that you can “identify” which contributions to roll over. You are not able to cherry-pick the non-deductible contributions when pulling out money from your IRA. If you decide to roll over $20,000 of your traditional IRA to a Roth IRA, you will be creating $16,000 of taxable income at the time of conversion.

Bonus: The 20% Qualified Business Income Deduction

Small business owners are entitled to a 20% deduction on your business income as long as you fit neatly into the income box that enables you to capture this deduction. When you go outside of this box, it can be extremely painful because you lose the 20% deduction of that income. For individuals, that income range starts around $170,000 and gets fully phased out around $220,000. For married couples filing a joint return, that income range starts around $340,000 and phases out around $440,000.

For some businesses, this phase-out can be overcome with a few additional tax maneuvers that stretch beyond the scope of today’s article.

Creating additional income through Roth conversions for small business owners that are above the QBI income thresholds may be one of the worst things you can do. For some business owners, deferring income into a 401(k) or traditional IRA may be the better decision.

The final take-way: Having a partner in your corner who understands how the Internal Revenue Code intersects with your individual financial situation is critical.

For additional help with Roth conversions or assistance in building a comprehensive strategy where all of your financial decisions are perfectly aligned with your most deeply held values and long-term goals, reach out to Monotelo Advisors by clicking below.

This article is a general communication being provided for informational and educational purposes only and is not meant to be taken as tax advice, investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions, inflation or US tax policy. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.

LEGAL, INVESTMENT AND TAX NOTICE. This information is not intended to be and should not be treated as legal, investment, accounting or tax advice.


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