In the previous post, I discussed the key facts you need to know about Roth investment accounts. In this installment, we’ll switch to discussing Roth conversions. Specifically, what they are, the benefits of doing one, and when they make sense to do. A Roth conversion is a great tool that savers have at their disposal to take advantage of different tax rates throughout their life.
In the previous posts covering traditional IRAs and Roths, we specifically discussed the tax treatment of both contributions and withdrawals. Understanding this is critical to knowing why Roth conversions are a valuable option for you.
First, let’s start with understanding what a Roth conversion is. A Roth conversion is the process of moving funds from a traditional IRA account into a Roth IRA and in the process recharacterizing the funds from a tax standpoint. To do this you need to have opened both a traditional IRA account that is funded and a Roth IRA account (this account does not have to be funded).
As we learned about traditional IRA accounts, withdrawals are treated as taxable income, and the same applies when doing Roth conversions. Any amount that you convert from a traditional IRA to a Roth will be added to your taxable income for the year and be taxed at your marginal tax rate. For example, if a married couple with a taxable income of $100,000 does a Roth conversion in the amount of $25,000, their taxable income increases to $125,000. As this income is in the 22% range, they would owe $5,512 in income tax on the amount that was converted.
So why would someone want to do this if you have to pay $5,500? The reason is that the $25,000 now in the Roth account will grow tax-free and won’t be taxed a
t the time of withdrawal either (assuming rules are followed for qualified distributions). That can be a very compelling reason. This $25,000 growing at 6% over 20 years will grow to just over $80,000. This $80,000 is now tax-free for the couple when they need it in retirement.
There are other advantages as well to doing Roth conversions:
Reduces amount in IRA which in turn reduces future RMDs and the corresponding taxes
Roth IRAs are not subject to RMDs so provide flexibility with an option for tax-free retirement income planning
Roth IRAs provide a way to pass assets to your heirs without them owing taxes
Provides a workaround for IRS income limits on being able to contribute to a Roth
This chart below shows the financial benefit of doing a series of Roth conversions and how it shifts the balance over time from the IRA to Roth account and how that will reduce future RMDs and related tax liability.
So why wouldn’t everyone do this? One, you need to pay those pesky taxes in the year of the conversion and you may not have the cash to do that. Second, it may not make financial sense, believe it or not, given your current circumstances. Ideally, you can take advantage of Roth reconversions when you are in periods of paying low tax rates. Let’s walk through a few scenarios using our same couple from before.
1. Let’s adjust the couple’s income to $50,000 which is in the middle of the 12% tax rate. Converting
$25,000 still keeps them in the 12% tax bracket. Let’s assume they are both 35 years old and that as time goes on their income increases and prior to retirement their income grows to $200,000. Between what they were able to save and Social Security, their retirement income projects to be $175,000 which is in the 24% tax bracket. By doing a Roth conversion when they did they were able to pay 12% in taxes on the conversion to later avoid 24% on the withdrawals. That is a great scenario for doing a Roth conversion.
2. Now let’s assume our same couple is age 50 and are in their peak earning years. Their income has grown to a combined $350,000 which puts them in the 32% tax bracket. They now have an expected $225,000 retirement income. Doing a Roth conversion at this point and paying 32% on the conversion to avoid paying 24% later does not make much sense.
3. Our couple is now making $170,000 and expects to have $125,000 in retirement income. The $170,000 current income is in the 22% tax bracket as is $125,000 retirement income. But, the $25,000 Roth conversion is additional income which pushes their current income to $195,000 and the incremental $25,000 is almost all in the 24% tax bracket. In this case, they would pay the higher rate on almost the entire conversion amount.
The basic premise boils down to taking advantage of lower tax rates now compared to projected future higher rates. The best way to do this is when you are in a lower tax paying year to try and fill up the lower tax bracket with Roth conversions. In our first scenario listed above, the couple has $100,000 of taxable income. The 22% bracket goes all the way up $171,500 in 2020 meaning if possible they could convert $71,500 and still be in the 22% tax bracket.
Here is a list of times in life that a Roth conversion might make sense:
Early retirement. Say you retire at age 60. You are not yet eligible for Social Security and do not have to start taking disbursements from your IRA/401k accounts. This can be a period of lower income and can be a perfect time for Roth conversions. Take a couple that retires at age 62 and is planning to live off money in their savings account and investments from a joint taxable account. The savings money can be used tax free and the taxable account will only result in income to the extent of the capital gains. Say this results in $25,000 in taxable income. That still leaves $55,000 of room to do Roth conversions and stay in the 12% tax bracket.
Early career. When starting your career your salary tends to be lower than it will be later in your career and as a result likely puts you in a lower tax bracket.
Economic hardship. This one can be tough because at a time when your income is lower due to a job loss or other economic conditions, volunteering to pay additional taxes for a Roth conversion may not seem like a smart thing to do. If other areas of your finances are intact though and you can ride out the temporary dip, the timing might be right.
Expected tax increases. In 2018 Congress passed the law to reduce our tax rates. One thing many people may not know is these lower rates are set to expire after 2025. That means all rates across the board may go up at all income levels.
Income is at the lower end of the tax bracket. This is especially important when there is a large increase in the rate of the next tax bracket. There isn’t a huge difference between $80,250 up to $326,600 which covers both the 22% and 24% tax brackets. Contrast that with $80,250 which is the tipping point between 12% and 22% brackets. Likewise $326,600 is the tipping point between the 24% and 32% brackets. If your income is at $200,000 you have $126,600 remaining in the 24% bracket to take advantage of conversions. Compare that to if your income is at $315,000 which only leaves $11,600 in the 24% bracket. Any conversion amount greater than $11,600 will be taxed at the much higher 32%.
There is one important caveat to know with Roth conversions and it is called the 5 year rule. Any amount converted to a Roth must be in the Roth account for a period of five calendar years in order to avoid the early withdrawal penalty and have earnings taxed. Five calendar years only means that the funds have to be in the account covering five different years not five full years. For instance, a conversion made in December of 2020 covers all of 2020 meaning a withdrawal in January of 2024 counts as year 5. This holds true for each conversion performed. Once an individual turns 59 ½ the five year rule no longer applies.
The Roth conversion can be a very powerful option in your financial planning toolkit. If used correctly you can pay a lower income tax rate on your contributions and get to take advantage of the huge benefit of tax free growth. You just need to know when to do the conversion so you can take advantage of the benefits it can provide. If you are interested in understanding if you are a good candidate for a Roth conversion drop us a line at info@7thstfinancial.com.
I hope you found this helpful and informative. Look for the next post where I will continue discussing additional forms of Roth conversions, the backdoor Roth conversion, and the Mega backdoor Roth conversion.