Roth conversions are a hot topic in the soon-to-be, and recently, retired circles and there’s good reason behind this. A well timed and executed Roth conversion strategy can potentially save you thousands of dollars in federal tax liability over the course of your retirement. Read on to learn what a Roth conversion is and if it can benefit you.
What is a Roth Conversion?
Simply put, a Roth conversion is the act of taking an eligible distribution* from a Traditional IRA, paying taxes on the withdrawal and putting the funds into a Roth IRA.
I know what you’re thinking; what kind of sick, twisted person would choose to pay taxes when they didn’t have to? For a better understanding of why someone would willfully increase their current tax liability, let’s first take a look at the following table to highlight some of the important differences between Traditional and Roth IRAs.
|Traditional IRA||Roth IRA|
|Money Going In (Contributions)||Tax Free||Taxable|
|Money Coming out (Distributions)||Taxable||Tax Free|
|Required Minimum Distributions (RMDs)||Must begin the year following age 70 ½||Never required for the account owner**|
**Inherited Roth IRAs are subject to Required Minimum Distribution rules
As you can see, the IRS gives us a break on contributions to a Traditional IRA. We aren’t subject to tax on what we put into the IRA, our contribution is considered “pre-tax”. When it comes to the IRS, however, every “gimmie” has a “gotcha.” The “gotcha” in this case is that you have to pay the taxes when you withdraw money from your IRA. These distributions from an IRA are treated like earned income. The more you distribute, the larger the tax implication. Even worse, the Government begins to force you to withdraw funds from your IRA after you turn 70 ½, this is called your Required Minimum Distribution.
The Roth IRA on the other hand, gives you no tax break on the money you contribute. Instead, you get the benefit of tax deferred growth and tax free distributions when you withdraw money from your Roth. No tax bill at all for qualified distributions and no Required Minimum Distributions until someone inherits your Roth IRA.
So tax free withdrawals from a Roth IRA sounds pretty good, but paying all of those taxes up front when the conversion takes place is still a tough pill to swallow. So how can a Roth conversion help you?
Can I Benefit From a Roth Conversion?
This is where you time on the playground really starts paying off. Do you remember playing on a seesaw? If you’re having a tough time recalling, here’s what they look like.
Now it’s time to put our imaginations to work. Let’s pretend that the ends of the seesaw are tax brackets, the low end goes with a lower tax bracket, the high end goes with a high tax bracket. We can look at the rest of the seesaw as the passage of time. The left side is your current tax bracket; the right side is your future tax bracket. Now we need to figure out which side is low and which side is high. If the left side (your current tax bracket) is lower than the right side (your future tax bracket) you may benefit from a Roth conversion.
Most people worked and socked money away into an IRA or Traditional 401(k) (distributions from a 401(k) are treated in the same way as a Traditional IRA from a tax perspective) avoiding taxes all the way under the assumption that your taxable income will be far lower in retirement than in your working years. All of that diligent saving and tax free growth on your investments may have caused an unexpected problem. For large IRAs and 401(k)s, those Required Minimum Distributions mentioned before can be so large that they will push you into a higher tax bracket years after you stopped working!
Let’s Take a Look at an Example
A 67 year old couple has saved diligently in pre-tax retirement assets like Traditional IRAs and 401(k)s totaling a little less than $1,680,000 that is growing by 6% annually. They have retired and are currently living off of pensions that total $76,000 a year between them both. For simplicity’s sake, we are disregarding Social Security in this example. This level of income puts them at the bottom end of the 25% tax bracket. Due to the U.S.’s progressive tax system, most of their income is taxed at 10% and 15% for an effective tax rate of a little less than 14%.
By the time this couple turns 70 ½, their pre-tax retirement assets has grown to a total of $2,000,000. Due to their age, it’s time for them to address their first Required Minimum Distribution. With a prior year end value of $2,000,000, their first RMD is $72,992.70 (the calculation of the RMD is beyond the scope of this post, more information can be found in IRS publication 590). Since this distribution will be treated as income, the couple’s total taxable income has grown to $148,992.70. This level of income is near the top of the 25% tax bracket and the couple’s average tax rate has grown to over 19%. With growth of their retirement assets and the nature of the RMD calculation, this increase in tax liability grows even more over time. With continued 6% growth, the couple is facing an RMD of over $160,000 by the time they are 85. This plus their pension income gives them a total income of $236,000, landing them in the 33% tax bracket and they haven’t worked in nearly 20 years!
So how do we limit the couple’s taxable income later in their retirement? You guessed it, Roth conversions. Since the couple in the example is in a lower tax bracket early in retirement, they’ve passed the “see-saw test” and Roth conversions may be able to help. We’ll have the couple perform three Roth conversions in the three years between their retirement and when their first RMD will be due. We’ll take taxable income from their retirement assets that “fill” their income to the top of the 25% tax bracket and no more and put those distributions into a Roth IRA. By lowering the couple’s pre tax asset level with Roth conversions, they have reduced their tax liability throughout their retirement. That RMD at age 85 that had pushed them into the 33% tax bracket before the Roth conversion will have been reduced to keep them in the 28% bracket and they paid taxes at their current, low tax rate to do it.
It goes without saying that a proper Roth conversion strategy is highly complex and there are many factors to consider that haven’t been covered in this short post. If you think Roth conversions may help lower your future tax liability, contact us at Innova Wealth Partners to learn more.
*For a distribution to be recognized as eligible, the withdrawal from your Traditional IRA must occur after you turned 59 ½. Take a withdrawal from a Traditional IRA before that age and you’ll be hit with a 10% penalty for an early distribution.
Read more about Roth Conversions Here: