Welcome back to Powering Your Retirement Radio, I am your host Dan Leonard. Today we are going to talk about Roth Conversions. First I am going to remind you that this is for educational purposes, please talk to your advisor or a tax professional before making any decisions. If you don’t have either I conveniently am both.
Okay, Roth conversions are on sale. Let’s look at what to consider when considering a Roth conversion. If you believe we are in a downturn and the stock market will hit new all-time highs at some point, you need to consider a Roth Conversion.
Okay, let’s tackle each one of these.
Your Current Tax Rate: This is what it will cost you to convert the money today. If you are under 59 ½ you should pay this from savings, not money from your IRA since there would be a penalty on the distribution that is used to pay the tax. If you are over 59 ½ you can use the money from your IRA, but you are making a bet that future tax rates will be higher, and at least the same, so essentially you are prepaying your current tax liability.
Available cash to pay taxes created: If you are under 59 ½ and do not have cash on hand to pay the taxes for the conversion, it probably doesn’t make sense to pay an additional 10% penalty to convert your retirement dollars. If you have many years 20 to 30 plus and expect good returns I could make a case for the conversion. As a generic rule of thumb, you should have the cash to pay the taxes.
Time Frame until you need the money: If you are going to do a conversion, I tell my clients you want to hold that money in the account for at least 5 years. If you are approaching your Required Minimum Distribution(RMD) Age, which is 72, remember money in a Roth IRA is not subject to an RMD.
Total anticipated retirement income and savings: This is probably the hardest number to nail down, especially if you are still working. The reason this is important is that once you reach 72 your RMD kicks in and in many cases grows each year. The older you get the more money you need to withdraw and pay taxes on. If you have done a good job saving, in my experience your RMD at some point becomes more than you need or want to spend.
However, if you haven’t saved as much and need more than your RMD, you never have that moment where you are upset about your partnership with the US Government. Whether you realize it or not, the money you save today and receive a tax deduction on is a partnership with the government. You avoid income tax today and receive tax-deferred growth and agree to pay ordinary income tax on that money later at those income rates. Most people do this, instead of paying tax today and then investing their dollars in something they would have to pay each year as they go along, and then pay capital gains on the positions they hold for longer than 1 year.
The anticipation of your future tax rates: If you believe tax rates will be higher in the future, you would be wise to prepay your tax obligations. If you think they will be lower, you would want to wait. If you don’t think they will change, it doesn’t matter.
Okay, this is the case for a Roth Conversion in general, but why are they on sale?
The S&P 500 index has dropped from just under 4,800 to just under 3,800 since the beginning of the year. Which is just over a 20% decline. Let’s say you want to convert $100,000 in January. If you did that you converted $100,000, paid tax on $100,000, and currently have $80,000, and you paid the tax on $100,000. That seems wrong at least at the moment. If the market recovers, everyone feels better.
Now let’s say you had a crystal ball, and you know to wait to convert until now. If you converted $100,000 today, the taxes haven’t changed, but you have converted roughly 20% more shares and when the market recovers it would be the equivalent of $120,000, and only have paid taxes on $100,000. If you could save taxes on $20,000 would that be worth it?
If you are in the 32% tax bracket, you have to think twice. If you think you will be in a lower tax bracket in retirement, you have to think twice. There are many variables to consider, and doing a conversion is something to consider unless you think the market has more to fall. You also have to have an idea of what your full year’s income will be including the conversion amount.
These are a few of the many considerations for Roth conversions. Please talk to a tax consultant who can help you think through how the one-time increase in income could affect your Medicare premiums in addition to other income-based taxes.
That is it for this week and until next time, Stay safe and be well.