Roth Conversions, A Tax Planning Strategy

By VWG Wealth Management on August 23, 2021

What are they?

A Roth conversion is the (strategic!) process of transferring monies from an existing pre-tax retirement plan (Traditional IRA, 401k, 403b, etc.) into a Roth IRA.  As a reminder, a Roth IRA is a retirement account that is funded with after-tax dollars, but any growth and future withdrawals are tax-free.  When you convert to a Roth IRA you are moving retirement dollars from your current tax-deferred vehicle into an account with tax-free growth and withdrawals.  The amount you convert counts as taxable income in the current year, but now any future growth in the Roth IRA will be tax-free when you take withdrawals later in your retirement.  This tax-planning strategy is one many folks nearing & entering retirement tend to consider as it could help reduce the future tax bill they owe Uncle Sam.  With that said, Roth conversions can be efficient across many different financial scenarios, not just those entering the decumulation phase in their life.

There are many factors to consider when deciding whether a Roth conversion would be beneficial for you, such as “How much do I convert in any one year?” and “When in my life should I start these conversions?”  All great questions – let’s first unpack some of the key advantages of doing a Roth conversion and then we can start thinking about how much and when conversions make sense given your unique situation.

What are the pros and cons?

One key benefit of a Roth conversion is the potential to lower your overall tax burden in retirement, something we’d all like to do.  Surely predicting where tax rates will be in the future is a no-win game, but you can often assess what your income will be in the future compared to today.  Efficient tax planning means paying tax when your relative rates are lower and avoiding them (when possible) when they are higher.

Another advantage to Roth conversions is the ability to watch your money grow tax-free for a longer period.  Roth IRAs have a unique advantage that pre-tax accounts don’t – they aren’t subject to Required Minimum Distributions (RMDs) starting at age 72.  In fact, Roth IRAs do not require you to take RMDs at any age allowing your retirement dollars to continue enjoying tax-free growth.  Let us not forget that RMDs are considered taxable at ordinary income tax rates!  Consequently, RMDs grow significantly as you age thus your income and tax bill continues to increase over time which also has indirect results such as higher Medicare premiums, increased tax rate on your social security benefits, and your capital gains and dividends. It is very common for retirees to “assume” their tax bracket will be lower in retirement, however often times that is not the case.

In addition to approaching your tax situation favorably today, Roth IRA conversions can also have a meaningful impact on your beneficiaries who inherit these accounts.  The SECURE ACT Congress passed in December 2019 made significant changes to the retirement regulations, including the elimination of the “Stretch IRA.” Using this strategy, a beneficiary could slowly take money out (via RMDs) over many decades because the RMD was based on the beneficiary’s life expectancy, thus keeping their tax burden low.  Now, an heir to an IRA must withdraw the full amount in 10 years or less and pay related taxes.  But alas, while beneficiaries of a Roth IRA must empty the account in 10 years or less, they will NOT have to pay any federal income tax on their withdrawals.  This gives your beneficiaries a significant tax benefit, especially considering most inheritors are still working and receiving income, often already putting them in a relatively high tax bracket.

Although there are clear advantages, we must consider some of the drawbacks when attempting to implement this strategy.  As discussed earlier, you pay income tax on the amount you convert to the Roth IRA which could present you with a significant tax bill.  A problem you could run into is not having enough cash to cover your upcoming tax bill.  Also, if you are younger than 59 ½ and use some of the conversion amount to pay the taxes, you could trigger a 10% early withdrawal penalty.  Be cautious and ensure you have enough non-retirement funds to pay for the conversion which is at ordinary income tax rates.  In addition, there is also a worry about miscalculating and converting too much in any one tax year.  It is important to talk with your advisor about planning these conversions, so you don’t accidentally convert too much and push yourself into a higher tax bracket!

How much and when?

Determining how and when to convert to a Roth is not an easy question to answer.  The decision depends on your current and future spending goals, future income from social security and other pensions, the future direction of tax rates, and other factors.  Because Roth conversions generate income, there is some strategy to synchronizing these conversions into your overall retirement plan.  So when might be a good time to make Roth conversions?  Many folks convert early into their retirement when they are no longer drawing an income and enjoy a reduction in their tax rates.  Or, it might be opportune to convert if just one spouse retires while the other continues to work.  In both situations you might be in a year that your household income could fall to a lower tax rate than normal.  If you find yourself in a lower tax bracket today, then considering filling up your tax bracket with Roth conversions might be a clever strategy.  “Filling up your bracket” means maximizing your current federal tax bracket.  As an example, a household whose annual income is $225,000 is firmly in the 24% tax bracket ($172,151-$329,850).  Doing Roth conversions to fill up the 24% bracket would allow this household to convert $104,850 without pushing them into the next tax bracket which jumps UP to 32% rate.

Bottom line is this: tax planning it a critical component to your financial plan and as you travel along your financial journey there might be pockets of opportunity to take advantage of this type of strategy.  Speak to your VWG Wealth Advisor about your situation and if any changes are set to occur in the near future.  Roth conversions, although potentially beneficial, need to be implemented carefully and strategically.

Tax Disclaimer Hightower Advisors, LLC is an SEC registered investment adviser. Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.

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