Our nest egg has to last for the next 30-40 years to fund our roving retirement lifestyle. Therefore, I spend a considerable amount of time thinking about and managing our money, generally, and minimizing taxes, specifically. Today, I have some timely information regarding Roth Conversion to share.
I am not a tax professional. Please consult your own tax professional before taking any action on the ideas presented below.
The What, Why and Who of Roth Conversions
In Roth IRAs and Living Chapter 2 I explain Roth conversions. For those of us with diminishing attention spans, I will boil down the why: Because it can help you pay fewer taxes.
I see taxes as liabilities that extend through a lifetime and beyond to one’s heirs. My goal is to minimize that liability while maximizing potential returns on my funds. A key factor is thinking about what your income and the resulting personal tax rate will be over your lifetime. You can use that analysis as a guide for when you want to recognize income via a Roth Conversion and pay taxes on that income at a favorable rate.
Roth conversion is mostly beneficial if you are no longer earning significant income. If you are still
contributing to society earning a living, have a look at Grab a Cool $100K with a Roth IRA for a way to mix Roth and Traditional IRA contributions for overall tax savings.
Reasons to Think About Doing One Now
- Buy on the dip
- Time is on your side
- Historic debt
- Because your parents love you or you love your children
1 – Buy on the Dip
A common belief among stock market investors is that one can do well by investing in the market when it makes a temporary decline, i.e. buy (shares) on the dip (in prices), getting those shares for a discount. The same theory applies to Roth conversion, only in this case, you are converting a larger percentage of your IRA funds to tax-free growth for the same amount of tax paid. As I write this article, the market is down roughly 6%, year to date.
Here is a chart showing the impact of Roth converting $100k after a 6% “dip” vs without the dip:
Basically, that 6% dip turns into an extra, tax-free $16k in 10 years, at no additional tax cost. If you already plan to Roth convert some funds this year, why not do it when the tax impact is greater?
2 – Time is on Your Side
The recent dip notwithstanding, the market mostly goes up over time, but timing the market is extremely difficult. Over the last 30 years, the average annual return of the S&P 500 is 10.72% yearly or 0.89% per month. If you convert $100k in February vs $100k in December, you get 10 more months or 8.9% more tax-free growth on that $100k even though you pay the same amount of taxes. And that extra $8900 will continue to compound in your Roth IRA over time, just like that bonus from converting on the dip. Of course, market return is not linear like this example, but the average return over time usually bears out this approach.
3 – Historic Debt
Your Federal Tax Rate is a function of your income, deductions, and whatever the government feels like making the tax rate at that time. The Tax Cuts and Jobs Act of 2017 reduced personal taxes through 2025. After 2025, taxes will go back up unless Congress acts to extend the reduction.
Meanwhile, Congress has so far added $7 Trillion to the national debt due to the pandemic. Many economists believe taxes will need to go up in the future to foot that bill. So taking income today, at what may be a lower tax rate, would save you from paying potentially higher taxes on future income.
4 – Because Your Parents Love You or You Love Your Children
The 2019 SECURE Act forced inherited IRAs to be distributed within 10 years after you inherit, not over your lifetime as before. Under this rule, the beneficiary may need to take large taxable distributions while also earning income, pushing them into a higher tax bracket (Egads!).
If you have a large Traditional IRA, Roth converting will take the tax liability and management responsibility away from your beneficiaries. Instead of a large, taxable Traditional IRA, you could be giving them a nice, big inherited Roth IRA, which they could let grow tax-free for the entire 10 years. If you anticipate inheriting a large IRA, you might consider showing your benefactor this paragraph :-).
Before converting, for this reason, it is worth reviewing future tax expectations for both the original owner and the beneficiary. After all, your young beneficiaries may be taxed at a lower rate than you, so leaving it to them to pay the taxes may be the smart move.
What if I’m Already Taking an RMD?
Even you are already taking a Required Minimum Distribution (RMD), Roth converting can still be a good move. Since RMD percentages increase as you age, taking more out of your Traditional IRA today can keep you from drifting into a higher tax bracket later. Meanwhile, your converted funds grow and can be used when needed without impacting your taxes.
Here is a chart showing your taxes paid over the years if you have a $2M Traditional IRA, with 8% growth and you only take out your RMD starting at age 72:
On the other hand, if you withdrew enough to stay barely within the 24% bracket (i.e. pay a little more tax now) instead of just your RMD in the early years, you would save about $60K in taxes over 20 years.
Paying the Taxes
Finally, most of the tax advice I have read on the net says you should only do a conversion if you can pay the additional tax out of cash you already have. Meaning, don’t take additional funds out of your IRA to pay the tax, because those funds are taxable too.
How does this sound to you?