Should You Increase This Year’s Tax Bill? The Case for a Roth Conversion
By Chris Hostetler
With a long-term view of tax planning, the goal is to reduce tax payments over time, not necessarily this year. It might actually make sense to pay a little extra now if it means you can save more money later. One of the best ways to do this is with a Roth conversion.
To understand this strategy, you have to be clear on the different tax treatment between the two main types of IRAs:
Traditional IRA – contributions are generally tax deductible, and then growth is tax deferred. You pay taxes when you take money out through a distribution. You can usually begin taking distributions after age 59 ½, but you MUST begin taking yearly Required Minimum Distributions at age 70 ½.
Roth IRA – you get NO tax deduction for your contributions. But the account grows tax free, and you can take distributions tax free. Furthermore, you never have to take Required Minimum Distributions during your lifetime – you’re welcome to leave these tax-free funds to your heirs. *Note: after you open your Roth account, you need to wait at least 5 years to distribute funds in order to avoid paying a penalty on funds that represent investment growth.
There’s a botanical analogy that helps clarify the difference: with a Traditional IRA, you pay tax on the oak tree. With a Roth IRA, you pay tax on the acorn.
So let’s talk about a Roth Conversion, which allows you to use the differences between these accounts to manage the timing of your tax bills.
The strategy: With a conversion, you take money from your tax-deferred IRA and move it into a Roth IRA. (You may also be able to do this in your 401(k), where the basic concept is the same.) You’ll pay income taxes on the amount of the transfer, which increases this year’s bill. Any future growth will occur in the Roth and will be tax free. (We like tax free!)
When to do it: There are a few ways to build Roth conversions into your plan.
If you have most of your retirement savings sitting in Traditional tax-deferred accounts, and very little in Roth or nonretirement accounts – you may want to do small conversions each year to gradually shift your portfolio Roth-ward. This gives you a more tax-balanced portfolio over time without generating an overly burdensome tax bill in any one year.
If you will have very low income for several years – you may consider doing larger annual Roth conversions before your income increases. For instance, you may have a window of opportunity after you retire and before you begin receiving Social Security and Required Minimum Distributions. Assuming you have a low-tax way to cover your living expenses, it could make sense to do large enough conversions to use up your lower tax brackets for the next few years, offsetting tax brackets that would be higher later on.
Some employers’ retirement plans allow for Roth conversions within the plan, e.g. a 401(k). This may come with an additional benefit if you’re maxing out your deductible contributions ($18,500/year if you’re under age 50). In some cases, you may make nondeductible contributions to your retirement plan and occasionally convert those funds to Roth; because the contributions are not initially deductible, the conversion is usually a very low-cost transaction.
*This is not available through every plan. Work with your professional advisors to determine whether it could benefit you.
Pitfalls: As with most tax strategies, we recommend you work with professional advisors to evaluate whether Roth conversions make sense for you. Here are a few of the things you’ll need to be aware of:
The obvious one: this year’s tax bill will be higher. Are you prepared to pay an extra tax bill this year?
Starting with this year’s new tax code, there is no do-over option with a Roth conversion. Prior to 2018, you had the option of preparing your tax bill and then “recharacterizing” a Roth conversion back into your Traditional IRA if you realized you had created too much of a tax bill. With the new rules, there’s no returning from a Roth conversion after you have done it.
If you increase this year’s taxable income too much, you may end up paying more for Medicare. If you exceed the threshold by even $1, your Medicare Part B bill could be more than $50 higher every month, two years from now.
Although the cost of a Roth conversion is significant, the benefits can be substantial. It may help you stretch your dollars further in retirement, or it may give your heirs a more valuable inheritance. Either way, the ideal scenario is to make conversions when your taxes are lower than they will be when you’re pulling the money out.
To make this decision, you need to prepare significant analysis and make some educated assumptions about investment growth, tax rates, your retirement lifestyle, inflation, etc. We do this kind of work all the time, and we look forward to helping you decide whether a Roth strategy is right for you.
This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation.
Hilltop Wealth Advisors does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state laws are complex and constantly changing. You should always consult your own legal or tax professional for information concerning your individual situation.