The Reality of Roth Conversions

If your goal is to never pay taxes again then converting qualified assets to a Roth IRA is one way to do it.  But if you really just want to pay the least amount of taxes over time then it may be best to leave your assets right where they are and adopt a different strategy.  In reality there are only a few specific situations where a tax-free conversion works.  I’ll explain first why it doesn’t work for most people and then give you a couple examples when it can work well.

First a disclaimer:  This post is meant only to provoke general thought and conversation in regards to an oft-promoted retirement strategy and should in no way be construed as tax advice or a specific recommendation on any particular tax strategy.  You should consult a competent tax advisor in conjunction with any retirement plan that includes conversion of a Roth IRA.

When a conversion happens all the money coming from an IRA is counted as taxable income on top of any other income you receive.  With our progressive tax system, the more money you make the higher taxes you pay.  Converting large sums of money to a Roth puts you in a higher tax bracket which may have you paying more in taxes than if you withdrew smaller amounts over an extended period of time.

This was certainly the case with Mike, who I met with last year.  He had a few years until retirement and thought a conversion might put him in a favorable tax bracket.  His goal was to retire in a 15% tax bracket and he was planning to spend the last three years of employment to get half of his IRA converted to a Roth.  If so his retirement withdrawals would eventually be taxed at half the rate as otherwise.  The problem is that the last few years of retirement are his highest earning years so a six-figure conversion would have him paying taxes on those fund in one of the most aggressive tax brackets.  It amounts to paying a significant premium for a small benefit down the road.  Plus, given his assets and income goals I calculated him to be just under the 15% threshold without doing anything so a conversion would add unnecessary complication since his goal was already attainable.

A similar situation happened with Candace who retired at 63 and needed to supplement social security with $30,000 per year from her IRA.  She thought it might be a good idea to convert an additional $100,000 per year to a Roth so at age 70 there were no RMDs and income from that point would be completely tax free.  First of all, $30K per year as her only reportable income puts her in a very low tax bracket.  The additional $100K conversion annually would have her paying taxes in a much higher bracket on the whole thing than if she just left it alone.  Plus during the time period of the conversion her social security payments would also be taxed at the highest rate which brings the cost up a touch more.  If she simply leaves all assets in the traditional account she will be able to meet RMDs, remain in a low bracket and pay a very modest amount of taxes each year.

The above two scenarios in a general sense fit the objectives of most people I know.  There are situations where the conversion works but those are more specific and I’ll explain below.

Richard has a sizeable portfolio and a modest retirement expenses.  He has lived within his means which helped him save a substantial sum.  Social security covers all his needs and he doesn’t like to spend money, preferring to manage his assets and leave them to his kids.  In this situation Richard has no taxable income so he can convert a fair bit of assets annually while staying in one of the lower tax brackets.  A Roth is superior to a Traditional IRA for inheritance purposes so he made a strategic decision to convert gradually to maximize the benefits.  His prudence and discipline helped create a nice portfolio so I have no doubt he possesses the perseverance and aptitude to make it happen.

In another scenario when it works, Charles retired early with a disability at age 60.  He has a private disability policy that pays until he is 65 and that income is tax-free.  For the five years he is receiving tax-free income he can gradually convert to a Roth IRA without paying high taxes upfront.  A similar strategy can be used when non-qualified investment losses can be deducted to offset additional income.  In either case conversions can be done while staying in a relatively low tax bracket.

A few of my clients use a different approach and I recommend it as an option for anyone who likes the idea of having more assets in a Roth IRA.  The maximum contribution to a Roth for anyone over age 55 is $6500 in 2019, or $13,000 when each person of a couple does it.  I’m also fairly sure that rate will rise over time, allowing for even greater contributions in later years.

Pulling an additional $13,000 from a Traditional IRA every year will not substantially affect taxes and if consistent contributions to a Roth average even 4% yield then there would be nearly $400,000 in the account after 20 years.  It provides a nice base for inheritance or tax free withdrawals in the later years of retirement.

So I’ll ask the question again.  Do you want to never pay taxes again, or pay the least amount of taxes over time?  If you are looking for a strategic advantage there first needs to be an advantage.  In most cases a significant Roth conversion is not the most profitable strategy.

As with everything else it comes down to an individual decision and variables are different for everyone.  If you have questions about whether a Roth conversion is the right approach go ahead and call or click below to make an appointment.

All my best,

Bryan

800.438.5121

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