Overlooked Roth Conversion Considerations in Alabama

Roth conversions are often an end-of-the-year exercise because the decision hinges so much on knowing your actual marginal tax rate – and that’s something you may not be able to accurately estimate until most of the year has played out.

However, it may be surprising to learn that early-year conversions may be more beneficial in the long-run.  This has to do with the fact that markets go up over time although there’s no guarantee of this in any given year. For example, if you convert $50,000 in January and over the year your investments grow 10% ($5,000), that growth occurs inside the Roth IRA, meaning it can eventually be distributed tax and penalty-free assuming all other Roth distribution rules are followed.

What are the other upsides to early-year Roth conversions?

Converting early in the year also allows for flexibility in the usage and the timing of different conversion strategies. One common and effective strategy is the “fill-up-the-bracket strategy”. Depending on a person’s taxable income, you fill up with Roth Conversion income any remaining amount in their current tax bracket up to where they’re almost in the next higher bracket.

Spreading out the conversions in equal amounts over time – monthly or quarterly – can also be effective especially if income is uncertain early in the year. Still, you could make an early-year conversion based on a conservative estimate of your income and reassess later in the year. If there’s still room in your current tax bracket, then make a second late-year conversion.

From a practical standpoint, early-year Roth conversions can make sense just to avoid the year-end crunch. CPAs are slammed, Custodians like Schwab and Fidelity have processing backlogs and can’t guarantee that transactions will occur in a timely manner, and there’s always the possibility of market volatility.

What caveats should be considered?

While there’s potential upside to an early year Roth conversion, there are a few important caveats to consider regardless of the timing of the conversion. One, if you are of the age when you must take a Required Minimum Distribution (RMD), you must take your RMD before converting any funds from your IRA. In other words, you can’t convert your RMD to a Roth IRA.

Another important rule to be aware of is that the Tax Cut and Jobs Act permanently eliminated the ability to recharacterize the Roth Conversion. Now, once a conversion is complete, it’s irrevocable – regardless of investment performance or tax implications.

With no more “undo button” available for Roth Conversions, it’s even more critical to do accurate planning upfront to estimate how the additional income from the conversion will impact your tax situation, to evaluate whether the conversion makes sense, and to have a plan in place to pay the resulting tax bill.

 With so much focus often placed on just staying within a certain tax bracket with the conversion amount, if you’re not cautious, the additional income from the conversion could potentially cause you to lose certain tax credits or deductions. In addition, for those on Medicare, it may trigger Income Related Monthly Income Amount (IRMMA) which is a surcharge applied to Medicare Part B and D premiums for higher-income beneficiaries.

Look at your income predictability when deciding if making an early-year Roth Conversion is best for your situation. If you’re retired and living on Social Security, regular distributions from your investment accounts, and a pension, then income is likely stable and predictable. This makes it much easier to estimate taxable income early in the year and allows for more confident projections in terms of how much to convert without triggering negative tax consequences.

How are state income taxes in Alabama impacted by Roth conversions?

Apart from how early in the year you make a conversion, one of the more overlooked areas of Roth conversion planning is how state income taxes can significantly impact the overall cost and timing of a conversion. Understanding how your state treats retirement account distributions is critical to making smart conversion decisions. For those retirees or soon to be retirees who are planning a move to a new state, it’s important to know that retirement account distributions – including Roth Conversions- are typically taxed by the state in which you reside at the time of distribution.

It's not enough to compare tax brackets across states. Many states have unique rules and preferences for taxing retirement distributions and Roth Conversions. In Alabama, Roth conversions are given limited preferential treatment by offering a partial exemption. Once you reach age 65, the state of Alabama allows an exemption of up to $6,000 per taxpayer for taxable retirement income each year. For example, a married couple filing a joint tax return, they can exempt up to $12,000 each year, not just once.

 What income qualifies for the exemption in Alabama?

This rule is often misunderstood, especially in the context of Roth conversions. The exemption applies to retirement income that would otherwise be taxable by Alabama, including:

·         Traditional IRA distributions

·         401(k), 403(b), and 457 plan distributions

·         SEP and SIMPLE IRA distributions

·         Roth conversion income (because a conversion is treated as a taxable IRA distribution for state income tax purpose)

Basically, if it’s reported as taxable retirement income on the Alabama tax return, it generally qualifies.

What income doesn’t count toward the exemption in Alabama?

Some income sources are already exempt and therefore don’t need the $6,000 exemption.

Items such as:

·         Social Security benefits (fully exempt at all ages)

·         Military Retirement pay

·         Most defined-benefit pensions (already fully exempt under Alabama rules)

·         Qualified Roth IRA distributions (already tax-free)

Again, the $6,000 exclusion only helps with income that Alabama would otherwise tax.

Here’s an example of how this would work for a couple, age 65 who file a joint tax return.

·         Roth Conversion: $80,000

·         Alabama exemption: $6,000 x 2 = $12,000

·         Alabama-taxable portion: $68,000

Assuming a top state tax rate of 5%:

·         State tax = $3,400

·         Without the exemption = $4,000

So, while the exemption is helpful, it may not be a big money saver, and it certainly doesn’t make the Roth conversion “tax free”. Instead, it slightly reduces the Alabama tax cost while the federal marginal tax bracket still dominates the decision to convert.  

What’s the bottom line?

Roth conversion planning, like any other strategy, should always be done in the context of your overarching financial plan. Despite there being a bias toward year-end execution, high quality Roth strategies are typically coordinated and timed over multiple years and with clearly identified guardrails. In this context, early-year conversions should be given full consideration.

And when it comes to how state income tax is impacted from a Roth conversion, know your state rules. Alabama is very retirement-friendly for certain types of retirement income, especially for defined benefit pensions, which may be fully exempt regardless of age. But traditional IRA/401(k), 403(b), distributions - including Roth IRA conversions – from one of these tax deferred accounts, are not “fully exempt after 65” – they just get that first $6,000/person.

Developing and implementing an effective Roth conversion strategy before retirement as well as during retirement can often save a significant amount of money in taxes over the course of one’s lifetime. Working with someone who fully understands your financial situation and who is knowledgeable of Roth conversion rules in general and in your state, can help maximize the opportunities available for conversion while avoiding any unintended consequences.

Knowing the rules is helpful; applying them correctly is where the value is—schedule a conversation.