As the calendar turns over, it is an excellent time to review your current tax situation and see if there are tax strategies that you can employ to lower your long-term tax liability. One of the go-to questions I frequently get from clients is, “Should I consider a Roth conversion?”. This question is great and can often lead to follow-up questions to see if a Roth conversion would make sense.
What is a Roth Conversion?
To elaborate on what a Roth conversion is, A Roth conversion occurs when an individual takes money in a pretax IRA, Traditional or Rollover, and converts that money to Roth dollars by transferring them to a Roth IRA.
This incurs a tax liability for the amount you convert, so if you transfer $10,000 from your traditional IRA to a Roth IRA, you would realize $10,000 in taxable income for the year. Unlike Roth contributions, there is no limit to the amount you can convert. So theoretically, if you wanted to and had a million dollars in your IRA, you could convert that entire balance to Roth.
When could this work for you
There are a couple of scenarios that I generally see as most optimal for Roth conversions and a couple of triggers associated with them.
Age: the younger a person is, the more time the money has to compound; the growth is all tax-free in a Roth IRA. So, converting a dollar that has 50 years to grow tax-free can significantly impact your overall tax liability in the long term. Remember, pretax accounts grow tax-deferred, but you will ultimately pay taxes on the growth, which should be substantial given a longer timeframe. If you convert $10k and pay 12% federal income tax, or $1,200 today, and that money grows to $100k and you find yourself in the same tax bracket, you could potentially save yourself over $10k in taxes.
Recently retired individuals or couples that have seen a significant drop in taxable income. This drop in income can open a window that allows them to target and fill up a certain tax bracket. The 12% bracket is often a good one to look at. The next bracket up is 22%, so there is a large jump after you get out of the 12% bracket.
When not to do this
There are also scenarios where doing Roth conversions does not make sense. The first would be a scenario where you do not already have significant pretax assets. If you do not have significant Traditional IRA assets, then there is generally no need to convert what you have to Roth. This is because if you use those pretax monies in retirement, you can usually spread your withdrawals out over several years and have minimal tax liability.
If you are close to retirement and are in a high tax bracket, then it also does not generally make sense to do Roth conversions. If retirement is right around the corner and you will see a decrease in taxable income, then it would generally benefit you to delay doing those conversions until you retire.
Lifetime span
The specifics of the amount and timing should always be thought of through the scope of a complete financial plan. Part of the planning process is determining tax strategies that allow clients to minimize their tax liability over their lifetime, not just in a specific calendar year. This is why it is essential to understand your spending needs in retirement as well as other sources of income such as social security and pensions.
If you wonder if Roth conversions would make sense for you, don’t hesitate to contact your financial advisor. At Whitaker-Myers Wealth Managers, we believe a financial plan is the answer to “am I going to be okay in retirement,” and we want to ensure we are looking at all aspects of your financial picture. We would be happy to meet with you and discuss your questions.