I recently wrote about several changes that occurred with the passing of the SECURE Act. Now, I want to peel back the layers of one of the topics I covered in that post, Roth conversions. Specifically, how investors implement these conversions and why they would consider this option.
If you’re unfamiliar with the terms Roth conversion or ‘back-door Roth,’’ in simple terms, it’s the process of taking money out of your tax-deferred account and depositing it into your Roth account. There are three options available to complete the process:
- In a rollover, you take a distribution from your Traditional IRA in the form of a check and deposit that money in a Roth account within 60 days
- In a trustee-to-trustee transfer, you direct the financial institution that holds your Traditional IRA to transfer the money to your Roth account at another financial institution
- In a same-trustee transfer, you instruct the financial institution that holds your Traditional IRA to transfer the money into a Roth account at that same institution
You may want to consider a Roth conversion if any of the following bullet points apply to you:
- You anticipate that tax brackets will change in the future
- You prefer tax-free income in retirement
- You want to avoid/reduce Required Minimum Distributions (RMDs)
You Anticipate Tax Brackets to Change in the Future
Fifty years ago, a taxpayer filing single with a $100,000 income incurred a marginal tax rate of 70%. This year, that same income is being taxed at a rate of 24%. To find a marginal rate lower than 24% at that same income level, you have to go back to 1916.
In 1916, an individual with a $100,000 income had a 7% marginal tax rate. Of course, $100,000 today isn’t what it was then. The equivalent of $100,000 in 1916 would be $2 million today.
So what’s my point? We currently find ourselves in an historically low tax environment. While no one knows where tax rates will be in the future, the quote “History doesn’t repeat itself, but it often rhymes” rings in my ears, making me wonder about tax rates increasing.
Higher Marginal Tax Rates in the Future
If you’re one of the people who believes tax rates will rise, even if it isn’t to the level of the 1970 rate, you may want to consider a Roth conversion. Let’s explore why. In the $100,000 income scenario, when you convert tax-deferred assets to Roth assets, you pay taxes on the amount you converted at the rate of 24%. If you are right and tax rates rise to 50%, in oversimplified terms, you saved 26% in taxes.
Lower Marginal Tax Rates in the Future
If you are in the camp that believes tax rates will be lower in the future, like they were in 1916, a Roth conversion for income planning shouldn’t be considered. Let’s explore why. By foregoing a Roth conversion and keeping your assets in a tax-deferred account, you defer paying taxes until you make withdrawals in retirement. If you are right and tax rates fall to 12%, in oversimplified terms, you saved 12% in taxes.
You Favor Tax Free Income in Retirement
If only 52% of employers offer a Roth 401(k), how do you position yourself to have tax-free income in retirement? You know at some point that you’ll be required to pay taxes on your investments. Fortunately, you have the flexibility of deciding when you pay. If you opt to pay the taxes now, you have a handful of choices to achieve future tax-free income. The most common options are through contributions to Roth accounts or through Roth conversions.
Roth IRAs, Roth 401(k)s & Back-Door Roths
Roth IRAs are great if your income is below the IRS limit for contributions. However, if your income exceeds contributions limits, you can fund a Roth 401(k) if it’s available through your employer. If your income exceeds the limits or your employer doesn’t offer a Roth 401(k), you have the option of making back-door Roth contributions.
The first two options are pretty self-explanatory. The back-door Roth option is the process of making non-deductible Traditional IRA contributions and converting those dollars into Roth dollars. Because you’ve already paid taxes on those dollars (the contributions were non-deductible), you can back-door your way into a Roth account.
A Roth conversion is another option for having tax-free income in retirement. Generally speaking, if your marginal tax rate is at or below 24%, you should discuss Roth conversions with your financial professional. By converting some or all of your assets, you’re making the decision to pay the taxes now versus paying taxes when you take distributions in retirement.
Retirement income planning is not a perfect science. It’s impossible to plan for unforeseen life events or changes to tax codes and laws that might occur in the future. Because of this, diversifying how you allocate your retirement savings could be the best solution for you.
Required Minimum Distributions
The SECURE Act increased the RMD age from 70.5 to 72 years. While you gain additional time for tax-deferred growth, you’re still required to take money from your account(s).
If you’re like most investors, the majority of your assets are in tax-deferred accounts. The question is, how can you reduce your RMDs and why would you plan for this?
How to Reduce Your RMDs
If you have been planning for your future income needs, you should have a good idea of how much income you’ll need to support your lifestyle. To show you how to reduce your RMDs, I’ll use a fictitious couple as an example.
A married couple needs $120,000 in retirement income and $75,000 will be received through their social security. To cover their shortfall, they need to withdraw $45,000 from their Traditional IRA.
The couple is now 72 years old. They were diligent in funding their retirement and have amassed $2 million in tax-deferred assets. The first year, their RMD is approximately $78,000 which is $33,000 more than their income need. Unfortunately, the IRS requires that they take the full RMD amount.
With proper planning, they could have contributed or converted $750,000 of their $2 million into Roth accounts lowering their tax-deferred account to $1.25 million. By allocating their assets this way, their first year RMD would be $48,000.
Utilizing the strategy shown here, they didn’t need to take much more than what they needed in the first year. They have $750,000 in Roth account(s) that continues to grow tax free, and the kicker, they aren’t required to take RMDs from that money.
Why An Investor Would Want to Reduce Their RMDs
Why would you increase your taxable income in retirement if you don’t have to? Using the table above as an example, you see that by having assets in a Roth account, your RMD was roughly $30,000 less and you saved around $7,200 in taxes. In oversimplified terms, $37,000 stayed invested, which is almost an additional year of your income needs.
The scenarios that I described here are by no means the limiting factors as to when Roth conversions may fit into your financial plan. They just happen to be the situations that I see most often. I advocate frequently for Roth contributions and conversions for many of the reasons I addressed in this article. You should also consider the tax consequences inherent in Roth conversions before electing to complete the transaction. If you answered “yes” to any of the bullet points listed earlier, you should explore the possibility of Roth conversions with your financial team.