Long-term tax strategy is a focal point of the “New Three-Legged Stool” approach. It’s crucial to ensure excess money doesn’t build up in tax-deferred accounts—and Roth conversions can help in this department.
I’ve written extensively about making Roth conversions in the past couple of years, hoping to empower people with the knowledge they need to make informed decisions. And while there are many situations in which it makes sense to convert, there are others in which it doesn’t. So, in this newsletter issue, I want to take you through the thought process behind IRA-to-Roth conversions.
Paying Roth conversion taxes
We begin with the principle that paying less tax is always better than paying more. No one wants to pay 30% in taxes on a Roth conversion now if they can pay less later. Higher tax disadvantages may be overcome if the money is left in the Roth to grow tax-free for an extended period. A financial adviser can help you determine your break-even point.
How Social Security impacts a Roth conversion
Taxes are not the only obstacle to consider when doing a Roth conversion. Anyone who draws Social Security benefits will need to consider the impact of a conversion on the untaxed portion of their benefit.
Retirees with provisional income below the base amounts of $25,000 (single filer) and $32,000 (joint filer) are not subject to tax on their benefits. But if you are above these thresholds, some percentage of your benefits will be taxed. For joint filers with incomes above an “adjusted base amount” of $44,000, up to 85% of benefits can be taxed. The income thresholds are not adjusted for inflation.
Forecasting Future Tax Rates
An important part of the Roth conversion decision process will involve forecasting future tax rates and comparing them to your current tax rate.
Start by calculating your income needs in retirement. The New Three-Legged Stool approach to planning involves balancing income from Social Security, personal savings, and employer-sponsored retirement plans.
It’s important to allocate some of this income to come from your Roth, some from your IRA/401(k), and some from your after-tax savings (the after-tax investments being entirely in stock investments). Historically, stock investments have generated 3% in dividends and 7% in capital gains. These numbers can be used to estimate the taxable income from your after-tax accounts. You can manage the taxable income from your IRA/401(k) by controlling the number of withdrawals you take each year, at least until you reach age 73.
The maximum taxable income for taxpayers filing jointly to stay in a 12% tax bracket is $94,300 in 2024. Tax brackets are typically increased by the rate of inflation each year. You could use a 3% inflation factor to estimate your bracket in the future. Anyone in the 22% tax bracket who estimates that they may soon be in a 12% bracket might want to wait to do Roth conversions.
Changes to Tax Law
Forecasting what Congress may or may not do is risky. Tax reform has been discussed for several years, and many believe there is a good chance Congress may reform taxes before the 2018 tax cuts expire at the end of 2025. A national sales tax and a value-added tax have been debated in the past. Neither of these taxes would impact IRA withdrawals.
There is also the possibility that current retirees would be exempt from tax increases affecting IRA withdrawals. Roth conversions should be approached conservatively for those who are near retirement. Those who are younger—and have many years of tax-free Roth growth ahead of them—could be more aggressive.
Help from the Stock Market
Always consider the stock market when planning a Roth conversion. A market downturn can represent an opportunity to convert shares to a Roth while they are worth less and generate less taxable income. Ideally, you need a source for paying taxes on the conversion that has not declined. Growth in a Roth is highly preferred to growth in an IRA. It may make sense to convert dollars slightly above your current tax bracket during a severe market decline.
Finally, deciding to convert to a Roth IRA doesn’t have to be all or nothing. Let your tax bracket be your guide when determining the amount to convert. Be sure to consult a qualified tax planner and financial adviser to ensure you avoid any tax traps that may be triggered.
Insights:
- It is generally best to do Roth conversions in a low tax bracket.
- A conversion may not be advisable in a low tax bracket if Social Security benefits become taxable.
- A bad year for the stock market could be a great year to do a Roth conversion.
Originally Posted: March 3, 2017
