Taxtember: ROTH Conversion

Taxtember: ROTH Conversion

September 08, 2020

Welcome to the second week of Taxtember.  Today we discuss ROTH Conversions. 

Over the next few years with the tax cuts put into place in 2018 and expiring in 2025, you are going to hear a lot of financial sites recommend doing a ROTH Conversion since tax rates are low. 

The reason to do this is that you think your tax bracket today will be lower  than your tax bracket in the future.   That requires two assumptions.  1) You can predict what the government will do with taxes in the future.  2) You have a forecast of what your retirement income will be in the future.  The first assumption is pretty much a guess.  The second assumption can be accomplished by Oldfather Financial using your retirement accounts, Social Security, and overall financial planning. (So, START HERE.) 

A ROTH Conversion is moving money from a IRA or 401k (which is pre-tax) and “converting” it to a ROTH account and paying taxes on the conversion.  For example, transferring $100,000 from an IRA into a ROTH while being in the 22% tax bracket will increase your taxes by $22,000.  With ROTH accounts, your earnings grow tax free and you do not have to pay taxes on any distributions. 

The reason you do this is because you have been a diligent saver over your lifetime.  You have done a good job of contributing money each paycheck into a SIMPLE IRA or 401-k.  You watch your balances grow over the years to a nice sizeable amount while saving on taxes each year.  When you finally retire, you begin to start withdrawing money out of that nest egg and then WHAM!  You get your tax bill because all of that distribution is considered taxable.  You may even be in a higher bracket because of the IRA distribution. 

Here is an great example of how to do a ROTH conversion:  Let’s say you have $1,000,000 in an IRA account and are 66 years old.  You are waiting to take Social Security until age 70 (smart move!) so your income will be low over the next 4 years.  Just convert $100,000 each year from your IRA into a ROTH to get some money into a tax free account.  The big advantage to doing the conversion is if you can pay taxes from another source other than the conversion amount.  So, pay the $22,000 in taxes from your savings and convert the entire $100,000.  In four years, you will have over $400,000 in a ROTH account and your IRA will be $400,000 lower.  That means your taxable RMDs (Required Minimum Distributions) will now be lower and you can take tax free distributions from your ROTH account if needed. 

Another example on a ROTH Conversion is for someone who is currently still working and has done a good job of saving money into an IRA account (or rollover from a 401k).    They can just do a mini-conversion over the years of $10,000-$30,000 while keeping their tax bill in mind.  After doing tax planning and you realize that  you will be in the 12% tax bracket and have a gap of $15,000 before you move in to the next tax bracket then just do a $15,000 conversion this year. 

Another bonus on ROTH accounts is for your beneficiaries.  With the passing of the SECURE Act, an inherited retirement account will have to be distributed within ten years.  If they inherit an IRA, all the distributions are taxable.  With a ROTH, you still have 10 years to do the distributions, but they are tax free. 

So, if you think this fits your situation, contact our firm on having your scenario modeled through our tax planning software.  You really need to have the planning done by a fiduciary advisor that will help avoid any tax surprises.  We will then contact your tax preparer after our discussion and provide them the tax forecast report. 

Next week……Tax Loss Harvesting