Roth Conversion: Tax Now or Tax Later?

Tax Now or Tax Later?

Most people are familiar with the traditional 401(k) system. Pre-retirement, the system seems to work great: traditional contributions are tax deductible, your company may be making matching contributions, and the money grows, tax deferred, for years!

However, we are now seeing the downside of saving heavily in 401(k)s as we have the first generation beginning to retire exclusively on IRAs and 401(k)s –which could be a tremendous future tax bill.

While you have been contributing to your traditional IRA and 401(k) for the last several decades, you are required to pay taxes on the deferred investments contributions. Once you retire and begin taking distributions, taxes will apply to the amount withdrawn.

Did you know that whenever you make a withdrawal from your 401(k) or IRA, it is taxed – just like the income from your job was taxed? So, when you are retired and need $80,000 from your IRA for living expenses, a new car, or a nice vacation, the deferred contributions will be taxed when withdrawn. If you are not 59.5 there is a 10% penalty on the amount withdrawn.

Also as one reaches 70.5 years of age, the government will require you to withdraw a minimum amount of money each year from your IRA and 401(k)s. This is known as required minimum distributions or RMDs. They start small, but could grow during your retirement.

Consider this hypothetical example:

A married couple, both retired and 67 years old, each with $500,000 in their rollover IRAs, invested in a 60/40 stock/bond split. Besides their $1 million in retirement assets, they have $100,000 in cash and CDs. Their IRA investments are projected to grow at roughly 7.2% per year.

Their only retirement income is a monthly Social Security benefit of $2,500 per month for each spouse. We will assume this benefit rises 2% per year.

They plan to spend $90,000 per year for the next 10 years, then expect for spending to decline to $75,000 per year thereafter. All living expenses increase 3% per year to keep up with assumed inflation.

Assuming one of our couple lives to be 95, how much do you think this retired couple will pay in taxes? (Assuming, of course, that there are no changes from today’s tax laws.)

$1.1 million! That’s basically the entire amount of their initial retirement investments at retirement age paid in taxes!

Does a Roth IRA conversion make sense for you?  

Since 1998, taxpayers have been permitted to contribute to a Roth IRA subject to income limits.  One way around those income limits is a Roth conversion that moves assets from a traditional IRA to a Roth IRA. But, there is a catch – The conversion involves paying taxes today, since Roth conversions count as income.

Because Roth conversions generate income, it is best to strategize the optimal time to perform the conversion in order to avoid an unnecessarily large tax bill. For many retirees, finding a period of low income allows for larger conversions with smaller tax burdens!  This is accomplished by filling up lower income tax brackets with a Roth conversion.

Consider another example:

A couple who has income after tax deductions of $80,000 which puts them in the 22% tax bracket.  They both have $500,000 in their IRAs and are considering converting one of the IRAs to a Roth.  By converting one of the IRAs, their taxable income will increase to $560,000, driving them up into the 35% tax bracket.

Instead of converting a large sum, they could convert as much as $88,400 and still remain within the 22% tax bracket which tops out at $168,400 for a married couple in 2019.  Alternatively, the couple might choose to convert as much as $241,450 filling up the remainder of the 22% bracket and all of the 24% bracket which ends at $321,450 for married couples filing jointly for 2019.  This is filling up lower tax brackets now in order to lower RMDs in the future!

Roth conversions are not the right strategy for everyone and, like any investment decision, there are potential risks.

Since performing IRA conversions means paying taxes today, you are making a bet that future tax rates do not decline significantly in the future. If tax rates were to fall, it might mean you could convert or withdraw assets at a lower tax rate later.

There are no guarantees the laws regarding the Roth stay unchanged over the next few decades.

Finally, Roth IRA conversions should typically only be done only for long-term investments. Since the process of converting your IRA account to a Roth results in taxes, it is best to take advantage of the Roth’s long term, tax free growth. If you convert and then need to immediately pull out the money, it may result in higher taxes than you would normally have paid.

Roth conversions have exploded in popularity over the last few years. Today’s low tax rates, and the changes in the tax laws have created significant benefits for those who convert their IRAs to Roth IRAs for retirement. The trick is not so much determining if converting IRAs to Roth IRAs in retirement is right for you – but how much to convert, and when.

The answer to that is tough to give. It takes thorough analysis of your spending, income, goals, and more to determine the best Roth conversion strategy. Are you ready to consider converting your IRA? Contact me to begin financial planning with cash flow analysis and tax observations to customize a strategy that fits you and decide the best plan of action for your long term goals.

The opinions/views within do not necessarily reflect those of Voya Financial Advisors.  In addition, they are not intended to provide specific advice or recommendations for any individual, attorney, accountant, or tax advisor regarding your individual situation prior to making any investment decisions.CN1458677_0122