How much would you pay today for lower taxes tomorrow? We’re frequently asking that question these days, as conditions are ripe to consider a Roth conversion.
What is a Roth conversion? Simply speaking, a Roth IRA conversion involves transferring retirement funds from a tax-deferred account, such as a traditional IRA or 401(k), into a tax-exempt Roth account.
Why would you consider it? Again, simply speaking, to accelerate income and pay taxes at lower tax rates. Roth conversions also give you control over when and how you’ll pay long-deferred taxes. The key is to identify the right time for you. We recommend considering a Roth tax arbitrage during a period when your taxable income is lower and your portfolio contains a substantial amount of qualified assets available to convert to a Roth IRA.
As the chart shows, over the last 30 years, we have witnessed a low tax environment. It is possible we will see an increase in tax rates in the future. That prospect makes the current tax environment far more preferable for incurring taxes. Even if we assume that tax rates always remain flat, our progressive tax system means there is a benefit to accelerating taxable income in low tax years to reduce your taxable income in higher tax years.
As an example, let’s discuss Martha and David, a married couple aged 65 and 64 earning high income and nearing retirement. Because of their diligent retirement savings, they have a considerable amount in their 401(k) and IRA accounts and can estimate that their future Required Minimum Distributions (RMDs) will become sizable later in life. In the years immediately following their retirement, they expect lower taxes since they will no longer have salaries. A picture of their tax liability through retirement shows an obvious valley in the beginning years, with a gradual incline as their RMDs increase over time.
Martha and David should consider a Roth conversion strategy over several years to actually incur taxes, filling in the valley and reducing the peak. The process of converting traditional IRA dollars to Roth IRA dollars is taxable as ordinary income, meaning the taxpayer will incur taxes in the conversion year. Thereafter, the reinvested conversions can grow tax-deferred and can be distributed tax-free by Martha and David or by heirs as an inheritance.
It is important to note that inherited Roth IRAs do have Required Minimum Distributions; however, these distributions retain their tax-free character and will remain tax-free for beneficiaries. This is more valuable to beneficiaries than inheriting qualified assets that are taxable and can no longer be stretched over their lifetime under the SECURE Act.
How much to convert each year is limited only by the willingness to incur income taxes, but other considerations do exist. Among those considerations are the availability of cash or assets outside of qualified accounts to pay the tax bill. Increasing your taxable income can also increase Medicare Part B premiums for income that reaches certain thresholds. In some cases, rates rise to as much as triple the lowest premium rates.
Martha and David have a taxable income target of under $325,000 per year to stay within the 24% marginal tax bracket. They expect making conversions over several years will reduce their aggregate taxes over the course of their lifetimes, and they estimate they will net a total savings of over $560,000 in taxes.
As a result of making conversions, they will also create a new pool of tax-free assets that they can use for themselves later or use to create a significant transfer opportunity by passing a tax-free asset on to their heirs.
While conversions require careful and thoughtful planning, Roth conversions can yield benefits on multiple fronts, from tax mitigation to efficient asset transfers, and help to fulfill multiple ambitions with one strategy.
Our clients benefit from tactics such as these because we take the time to create tailored investment strategies based on our clients’ individual goals, then combine our expertise with the expertise of our expert partners to best meet those goals.
Could you benefit from a more efficient tax strategy? Contact us today at email@example.com.
Debra Brennan Tagg and Sergio Garcia are CERTIFIED FINANCIAL PLANNER™ Professionals at BFS Advisory Group. They use their proprietary program, DBT360 Financial Plan, to help their clients prioritize their goals, leverage their resources, and address their risks. The planners at BFS Advisory Group teach the public and the financial services industry about the importance of values-based financial planning and investor education.