Roth Conversions. Are you doing them?
Growing your wealth and stewarding your resources wisely involves many moving pieces. One of those pieces is understanding how and when to pay the taxes on the income and investment gains that you earn. For this reason, we’ve always been big proponents of establishing a “Roth” bucket of retirement assets.
The juicy feature of Roth dollars is that they will never be taxed again (at least under current legislation!). By establishing and growing a portion of your retirement assets in this Roth bucket, it gives you greater ability to control the amount of taxes you pay in retirement. Without a Roth bucket, any distribution you take from your investments will require you pay taxes in some way. However, building a meaningful Roth bucket is challenging. Most people’s primary source of retirement savings is their 401(k), which is usually pre-tax. Additionally, the IRS limits the amount you can contribute to a Roth IRA in any given year. In fact, if your income is above a certain threshold, you can’t even make a direct Roth IRA contribution at all.
Enter the Roth conversion. A Roth conversion is simply moving money from your Traditional IRA to a Roth IRA. The purpose of this post is to help you think through the critical questions to consider with Roth conversions so that you will understand when it makes sense to take advantage of this valuable strategy.
Questions to Consider with Roth Conversions
- Do you expect to be in higher tax bracket now or in retirement? This is the central question to ask any year you’re considering a Roth conversion. The easy analysis is that if your tax rate this year is lower than you expect it to be later, a Roth conversion is a good idea.
- Where will you get the money to pay the conversion taxes? The main obstacle of a Roth conversion is that the amount that you convert is counted as income to you in the year of conversion, which means you’ll likely need to pay taxes on that income. It’s important to identify in advance how you plan on paying those taxes. If you have cash or a taxable account that you can pay the taxes from, it’s generally a good move. But if you’re planning on paying the taxes from IRA itself, it’s usually not worth it.
- Will you need the money in 5 years or less? There’s a 5-year waiting period before you can withdraw converted funds from your Roth IRA both tax-free and penalty free.
When does it make sense to convert?
- When you have no income in a given year. Any year you find yourself with zero income, and you have a Traditional IRA, this is a no-brainer to do a Roth conversion. You’ll convert an amount up to your standard deduction and you won’t pay any taxes on this conversion because the standard deduction will wipe out the income. Voila! Those funds will never be taxed.
- When you have lower income in a given year. Any year that your income is much lower than usual is a good time to be on alert. The amount you choose to convert will be up to certain tax brackets, depending on where you expect your tax bracket to be in retirement. It’s always a good idea to fill up the 10% bracket ($0 - $19,750 for married couples filing jointly), and it may even be worth it to fill up the 12% bracket as well ($19,751 - $80,250).
An Example to Illustrate
Michael and his wife Holly have $1 Million in a tax-deferred account. We’ll say it’s all in a Traditional IRA owned by Michael which he rolled over from a 401(k) that he had at his old employer, a regional paper company. They also have $100,000 in a taxable investment account, but no Roth money.
Unfortunately for Michael and Holly, they made no money this year. Michael left his management position at the paper company, and his new start-up venture was unsuccessful. Since Michael and Holly can use the standard deduction to offset the first $24,800 of income, Michael can convert that much of his IRA into a Roth IRA and pay no taxes on the conversion. A no-brainer.
Whether or not Michael should convert more than that depends on his income in retirement.
Let’s assume his IRA grows to $2 Million by the time he needs to begin taking RMDs, making his first RMD around $73,000. We’ll also assume between he and Holly, they expect about $60,000 of annual taxable income between pensions and social security. After the standard deduction, that puts their total taxable income in retirement at around $108,000, which is comfortably in the 22% tax bracket.
Michael should convert an additional $80,250 of his IRA into his Roth IRA, filling up the 10% and 12% tax brackets. He will pay $1,975 in taxes for the amount he converts in the 10% bracket ($19,750 x 10%) and he will pay $7,260 in taxes for the amount he converts in the 12% bracket ($80,250 - $19,750 = $60,500 x 12%) for a total of $9,235 in current taxes. That sounds like a lot, but for that price he gets to move $80,250 into his Roth IRA where it will grow never to be taxed again, avoiding higher expected tax rates in the future.
Finally, the only reason it made sense for Michael and Holly to convert an amount over the standard deduction is because they had funds on hand—the $100,000 taxable account—to pay the $9,325 tax bill. If they didn’t have that account, or didn’t have the cash on hand, the conversion wouldn’t have been a good idea.
Roth conversions are definitely not a one-size-fits-all strategy. Whether or not this is a good idea for you depends on a handful of factors, as we discussed above. That said, being strategic about how and when you pay taxes can make a meaningful difference in the after-tax growth of your wealth. Taking advantage of Roth conversions is one of the arrows in your quiver for being a tax-savvy steward of your resources.