For finances and investing, as for most important things in life, timing matters. In fact, the timing of events like when income is received and when taxes are incurred and paid on that income is one of the most important strategic considerations in retirement planning.
For many sources of income, taxpayers have little control over when the taxes come due. But one important exception is the taxation of income received from certain retirement accounts. In fact, taxpayers have an important tool that can give them more control over the timing of taxation: a Roth conversion.
Many people preparing for retirement are discovering the advantages of Roth accounts for their retirement savings. You probably remember that, unlike traditional IRAs, 401(k)s, and 403(b)s, Roth accounts are funded with after-tax dollars, meaning that you don’t get to reduce your taxable income by the amount of the contribution, as with traditional accounts. However, one of the principal attractions of Roth accounts is that, also unlike traditional retirement accounts, the funds withdrawn from Roth accounts in retirement are not counted as taxable income for most taxpayers. The other benefit of Roth accounts that appeals to many is that they have no annual required minimum distributions (RMDs), which means that the owner has more control over when money comes out of the account.
What a Roth Conversion Can Mean for Your Taxes
Because of these advantages, some taxpayers can benefit by converting traditional accounts to Roth accounts. But, because Roth conversions create taxable events (the transferred amounts must be converted from pre-tax to after-tax, which means paying taxes on the amount transferred), timing is very important. On the other hand, a Roth conversion can be a great way to create more tax-free income in retirement, even for those whose income may prevent them from contributing directly to a Roth IRA (employer plans like 401(k)s and 403(b)s are generally exempt from such income restrictions for contributors).
Converting traditional accounts to Roth accounts can be especially advantageous for those who believe they will be in a higher tax bracket in retirement than they are presently. This makes sense for many soon-to-be retirees who own their own businesses, as many of the deductions presently available to them may go away when they retire. Paying taxes on the funds now and obtaining tax-free income later can be especially attractive if you anticipate a higher bracket in your future. And because Roth accounts have no RMDs, you also have the option to leave the funds alone entirely (though any non-spousal beneficiaries who receive the account as part of an inheritance must take distribution of the full account balance within ten years).
A key detail to note is the Roth five-year rule. Each Roth conversion starts its own five-year clock. If converted funds are withdrawn within five years and the account owner is under the age of 59½, a 10% early-withdrawal penalty may apply to the converted principal (though taxes have already been paid). For most retirees who do not need the funds immediately, this rule is not an issue, but it is an important consideration for those creating a Roth conversion ladder for early retirement income.
From a timing perspective, there are two different periods most often recommended for Roth conversions. From the first year of retirement until the last year prior to filing for Social Security may be a window when the capacity for advantageous conversions is generally highest. Second, once Social Security starts, the opportunity is still there but to a lesser extent; this period lasts until RMDs start, which for most taxpayers is the year they reach age 73.
Pluses and Minuses of Roth Conversions
To convert from a traditional to a Roth account, you must pay taxes on the amount of the exchange, in return for never having that money taxed again, either as the Roth account grows or when you take the money out in retirement. But the math requires some careful consideration. Should you pay taxes now, or should you wait until the money comes out in retirement? As mentioned above, if you believe your tax bracket in the future will be higher than it is today, then the Roth conversion should save you money in taxes. If not, then it will cost you money. If the rates are the same, then the Roth conversion is basically a wash, as far as taxes are concerned.
But there are some other things to think about. Remember that if you convert, you are paying taxes today to get a tax break in the future. If today you deposited the funds you would not have paid in taxes into a side account, what rate of return might you receive? This is impossible to predict, but the same could be said for future tax rates.
A recent study compared several different factors and discovered that the length of time between the conversion and when the funds are withdrawn can influence the advisability of the Roth conversion. Of course, calculating this factor’s impact is also complicated, since we cannot accurately predict the future rate of return or the future tax rate. It’s also important to consider the tax and time-value-of-money cost if you must liquidate other parts of the portfolio today to pay those taxes on the Roth conversion.
Other Benefits of Roth Conversions
Another benefit that is often overlooked is that reducing future tax rates with a Roth conversion also reduces the IRMAA surcharge that the retiree must pay on Medicare premiums. Additionally, lower future retirement income may result in realized long-term capital gains from after-tax brokerage accounts falling into lower brackets, which are currently 0% or 15%. Of course, those future capital gains bracket thresholds are also impossible to predict.
Persons with capital loss carryforwards from taxable accounts may be able to use them to offset up to $3,000 of ordinary income per year (after offsetting any applicable capital gains), which can help reduce the tax bill generated by a Roth conversion. Also, those who have net operating loss (NOL) carryforwards, such as those generated by a business or real estate, may have an opportunity to convert traditional to Roth assets at lower rates, making future tax savings more likely. All things considered, most Roth conversions can be expected to reduce total taxes within the joint life expectancy of a typical married couple.
Finally, Roth conversions can provide a benefit for estate planning. Because retirement accounts typically have beneficiaries, much like life insurance policies, they can be passed along to a person of the account owner’s choice in the event of the owner’s passing. And, because Roth accounts have no RMDs, the account owner may elect not to withdraw funds if they are not needed for retirement. This means that the owner can, if desired, leave the account alone to continue growing and compounding tax-free, then pass the account to a chosen beneficiary when the owner dies. And, because beneficiary designations supersede the terms of wills and trusts, the account would go directly to the beneficiary without the necessity of going through the probate process.
If a Roth account is to be used in this way, the owner may, if desired, stretch the conversion process over a longer period of time (into the retirement years, even). The only stipulation is that a non-spousal beneficiary is required to liquidate the account over a ten-year period. This can also affect decisions about asset allocation. For example, if the account owner intends to pass the account to a grandchild, it could be advisable to invest it in assets that have more long-term growth potential, rather than those intended to generate income in the shorter term.
If you are wondering whether converting a traditional retirement account to a Roth account could help you save on taxes, why not reach out to your JFS advisor? We can work with your tax expert to determine if this strategy is right for your situation.
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