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When Does a Roth IRA Conversion Make Sense?
September 19, 2020
When Does a Roth IRA Conversion Make Sense?
There are a few factors that make converting a Traditional IRA to a Roth IRA more ideal. Currently, amid the pandemic, we have a combination of factors that have created a bit of a silver lining for those considering a conversion.
In this post, we’ll dig into when it makes sense to do a Roth IRA conversion and 3 reasons why it’s worth having a conversation about it right now.
First, let’s define a Roth IRA conversion. A conversion takes place when money from a Traditional IRA, where any prior contributions were income tax-deductible but where distributions during retirement would be taxable, and converts it to a Roth IRA. In a Roth IRA, contributions are made with after-tax money, so that when the rules for a Roth IRA are followed, it grows income tax free and qualified distributions would be income tax free during retirement.
You should keep in mind that taxes on the amount converted to a Roth IRA would be due in the tax year the conversion takes place. So for example, any conversions done January 1, 2020 through December 31, 2020, would be added to ordinary income when clients file their taxes in 2021. Contributions, funded with after tax dollars, may be made up to the filing deadline for that tax year. For example, 2020 Roth contributions could be made up until the filing deadline of 2021.
So, when does it makes the most sense and when is it even more advantageous for you to do a Roth IRA conversion? That’s what we’ll cover in this post.
1. When at a lower tax rate
If you feel taxes will go up in the future, you could be better off doing a Roth IRA conversion now. With the current state of the world and of the economy, as well as the need to offset trillion-dollar stimulus programs, many predict taxes will go up in the future. If that does happen, the amount owed on any conversion or amounts taken out of pre-tax retirement savings could be more in the future.
Additionally, some of you may have less income this year due to unemployment, reduced hours, or no bonus or raise-- this reduces your taxable income and might allow some room for your taxable income to increase with the conversion and still be manageable.
We’re also still under the Tax Cuts and Jobs Act until almost all provisions expire after 2025. The TCJA shifted the thresholds for some income tax brackets, lowering tax rates for the time-being. This is another reason it may make sense for you to consider a Roth IRA conversion right now.
One of the benefits of a Roth IRA is the confidence in KNOWING how much will be owed in taxes while letting gains grow income tax free. On the other hand, with a Traditional IRA, the amount that will be owed in taxes during retirement is based on what the tax rate will be at that time, which is yet to be determined.
You may be thinking that converting now results in few dollars working for you. For example, if you convert say a $100,000 IRA and pay 25% between federal and state taxes, you will only have $75,000 working for you going forward. That's a real concern for anyone, right? Maybe it shouldn't be.
Let's examine the math in a hypothetical example. Using the Rule of 72, we know that an account will double in 10 years at a 7.2% compounded rate of return-- $75,000 would grow to $150,000 in that case and $100,000 would grow to $200,000! That's a significant difference. At least until you pay the taxes...
Applying the same 25% combined federal and state tax rate, $200,000 becomes $150,000 after tax. It's the same outcome! However going forward, any interest or gains on the after-tax money will be subject to tax as well. That is not the case on a Roth IRA.
So, it makes sense to ask-- Will my effective tax rate be greater in the future or not? If the answer is yes, it may make sense for you to consider converting some of your Traditional IRA.
2. When a Traditional IRA balance has dropped
For many, the market hit their accounts hard and this can obviously be devastating. However, a reduced balance can be viewed as an opportune time to consider a Roth IRA conversion.
Since you would owe taxes on the amount converted, a lesser balance means less taxes due. That said, not every client will want to convert the entire amount of the Traditional IRA. Doing partial conversions over a period of time into an account and spread out their tax liability may be a good idea. Doing partial conversions can also be a good plan with large Traditional IRA balances.
3. When no Required Minimum Distributions (RMDs) are required
We are facing a rare situation in 2020 where individuals of RMD age are permitted to waive their RMD. Typically, an RMD must be taken in the year a client reaches age 72 (70 1/2 for folks who were already required to take a RMDs prior to the passing of the SECURE Act in December 2019 or who have Inherited IRAs) and every year after and that amount is taxable to you. What makes this a potential drawback when it comes to doing a conversion is that a person would have to take an RMD first before they could do a Roth IRA conversion—increasing their taxable income even more.
This year, however, a person would have the option to only be responsible for paying taxes on the conversion (if they chose to do one) and not an RMD on top of that.
Once it’s converted to a Roth IRA, another advantage is that there are no RMDs on the Roth IRA while the owner is alive. Therefore, you aren’t forced to take money out if you don’t need it.
In Conclusion
If you are wondering about how to improve your retirement outlook and find the positives in the current situation, it might make sense to introduce yourself to the idea of a Roth IRA conversion. And if you’d like to strategies that could make this even more appealing, reach out to us today. This is a conversation you do not want to put off.
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Let's talk about income sources. Which ones are the most tax efficient and as a bonus a few inefficient tax strategies just to be aware of. For the purpose of today's discussion we are not going to bring wages into play here. We are talking strictly about investment income sources. Income Source #1 ROTH IRA Income is the first and most obvious choice here. The benefit of the ROTH IRA if your not aware, (which is okay if your not - we are all about education here) is that you put your money in after you have already paid taxes but anything in the account grows tax free and can be taken out tax free in retirement. There are some nuances you have to be aware of like you must wait to take your distribution until you have had the account for 5 years you must be 59.5 years old but there are also some nuance early allowances like access to your principle portion at any time. But when it comes down to the general tax fee income it is really hard to beat the benefits of a ROTH IRA . We can discuss future pro and cons at another time. Income Source #2 Dividends Stock Income can be a very tax efficient income source for a lot of people. Now to offer some clarity here we are only talking about dividend income from stocks not held in any type of IRA or other qualified plan. The big advantage here is that "qualified dividends" are taxed at Long Term Capital Gains Rates which if you read our blog-post on that HER E , you would know have some major tax advantages. For Single filers you would pay 0% from $0 to $40,000 of income. You would pay 15% from $40,001 to $441,450 and 20% from $441,451 or more. For married filers you would pay 0% from $0 to $80,000 of income. You would pay 15% from $80,001 to $496,600 and 20% from $496,601 or more. As an example a married couple with $170k in income would be in the 24% tax bracket normally but in the 15% bracket on their dividends that were qualified . That is a pretty hefty amount of income taxed at very low rates. It is important to realize this style of investing does carry market risk and you will want to make sure this fits your overall goals and risk tolerance before diving in. Income Source #3 Real Estate Income can offer some wonderful tax advantages. Investing directly in rental real estate is a great way to leverage your wealth and get tax advantaged income but with prices at record highs this may not be the best time for that. The easiest way to invest in real estate is through publicly traded REIT funds that trade on the stock market. The main disadvantage of these types of holdings is volatility. Publicly traded REITs often have a high correlation to the stock market, which may be the opposite of what you are trying to achieve with this type of investment. Instead, consider looking into non publicly traded REITS. They often have a much lower correlation to the stock market as they are not traded like stocks. They get most of their value from the underlying real estate itself and not stock market share prices. But what about the tax advantaged income? The main advantage to rental real estate income is passthrough depreciation. That depreciation is given back to you as a tax deduction in the form of "Return of investment capital", meaning that portion of your income isn't really taxed right now. So lets say you got $20,000 a year in rental income but had $15,000 in depreciation or "Return of investment capital" that would mean you are only paying taxes on $5,000 of income on a $20,000 income source. How great is that. But there is a downside too. That depreciation lowers your cost basis which can increase your long term capital gains taxes if not planned for as part of your overall financial plan. If you want to talk about if real estate makes sense for you click below to schedule a time to chat. Income Source #4 Life Insurance holds many unique tax advantages. Much like the ROTH IRA you put those dollars in after tax. Like a ROTH it grows tax deferred and the distributions can also be tax free just like a ROTH but that is where the similarities stop. Unlike a ROTH there are no contribution limits or age restrictions or holding requirements. Some types even protect your cash value from loss while others are directly invested in the stock market. From a tax perspective here is what makes this strategy so unique. We already talked about distributions being tax free but did you know when you borrow money from your life insurance as income the income you take could still earn interest??? Since it is being taken out as a loan against the account the money stays invested. If you earn an average return of say 7% but only pay 4-5% in interest you are actually making 2-3% a year on income you already took out of your account. How great is that. That is called positive arbitration. The best part is your income is tax free and when you die your beneficiaries also get the remaining balance tax free as well. Income Source #5 Social Security Income can be one of the most tax efficient sources of income in retirement. If you have ever attended one our classes on Social Security planning you may know some of this already but for those that haven't or need a recap lets dive in. Social security can be anywhere between 0% taxable all the way up to 85% taxable. But the unique thing is that social security is never 100% taxable. So at now point will 100% of your check count towards you adjusted gross income for tax purposes. How cool is that. Now how much if it that is taxed is based on provision income. If you missed last weeks video on that click HERE . But basically the lower we can get your provisional income the less taxes you pay on your Social Security which could end up being a big deal long term. 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Basically if you own a mutual fund and it sells some of the holdings within the fund at a profit throughout the year you are liable for the taxes on that gain even though you didn't directly sell anything yourself. Believe it or not this can cause unintended consequences like putting you in a higher tax bracket affecting your Social Security income, IRA income etc. Certain ETF's - Certain ETF's also fall pray to this phantom income tax and may have the same unintended consequences. So can you, or should you utilize any of these top 5 Most Tax Efficient Income Sources? I hope this helps making that decision but if you still need helping figuring things out, click the button below to schedule a time to talk.