With the end of the tax year approaching for 2018, you may want to consider whether you should do a Roth conversion this year. A Roth conversion is an underutilized financial planning tool that many individuals and even financial planners overlook. The new tax reform, which effectively lowered the tax burden for many Americans made this strategy even more attractive than in previous years. How do you know if it is the right strategy to implement this year? First you need to understand the basics of a Roth conversion, factors that impact your decision whether you should convert this year, and a couple of common strategies of Roth conversions.
Here is a quick summary video:
Basics of a Roth Conversion
A Roth conversion is when you strategically decide to transition funds from a traditional retirement account like a 401(k) or Traditional IRA (both before tax income) into a Roth account (post-tax income). In this process you need to report the conversion value as income in the year the transaction occurred. That may sound like a raw deal, but what happens with the Roth account funds is pretty magical. Never taxed again! Even growth in the account is not taxed. Roth accounts are not perfect, however, you still want to use sound judgement in determining whether the tax you pay now may compare to what you may have paid in the future.
Future Tax Expectations
Where do you expect income tax rates to be in the future when you retire? They may be higher or they may be lower. You may feel very strongly that they may be higher. That belief could be a big driving force in your decision to start strategically paying taxes now at a lower expected rate than in the future. If you feel they will be lower, than it would be more favorable to avoid rolling over your investments. If you are like most people, you do not feel strongly one way or another and decide that you are not going to do anything.
I feel rates are more likely to go up than they are to go down. Many people were shocked at the generous reduction in taxes almost across the board with the recent tax reform that was passed last year, I was one of them! The United States government is running at a growing deficit and there are other social systems whose budgets are not managed nearly as efficiently as they should be. This is my primary reasoning to why taxes are more likely to increase in the future. This potential of a seven-year period for lower taxes until they are set to sunset in 2025 is a great benefit for those who think taxes may be significantly higher in retirement than they may be over the next seven years.
Unique Income Year
Independent of what Federal Income tax rates may be on their own is where you personally land in the United States Code tax bracket. Even if you expect future tax rates may be lower when you retire, if you had a unique income year, then you may want to still consider using a Roth conversion. A unique income year that I am referring to is a year were you receive substantially lower income than what you have in the past and what you are likely to earn in the future.
There are many factors as why this dip in income may have occurred. Some are uncontrollable negative events, but others could be great events that are worth planning for:
- Job Loss: Little or no severance pay
- Sabbatical: Reduced pay or no pay
- Going from two incomes to one: (raising children, starting a business, etc.)
- Gap in employment: (pursuing education, transitioning between two jobs)
- Career transition: (moving to new career at entry level to work back up towards higher pay)
Checkout: How to Build Wealth Strategy Guide
Expect Future Income to be Greater
This is most common with younger professionals in their 20’s and 30’s, but could also include career changers too! As your progress through your career you will pick up skills and experience that can add up to significant pay raises over your working career. As your pay increases throughout your career you are going to be shocked by how much taxes take a bite out of your true take home pay. Early in your career you are at lower tax rates, which is a great opportunity.
You may benefit substantially from making Roth contributions and Roth conversions (I will address the difference soon) during the early stages of your career. In the short-run you will be paying taxes now, but the long-term potential of tax free growth could dwarf the taxes you pay now. I always love to help my clients see the power of long-term decision making and all of their new possibilities they can create. With many areas in financial planning, you have to have a long-term view on strategies.
(Return rates and tax bracket projections are purely hypothetical for illustrative purposes.)
Current Age: 25
Retirement Age: 65
Base Savings Rate: $400 Monthly
Time Period: 8 years
Annualize Growth Rate: 5%
Current Tax Bracket: 12%
Retirement Tax Bracket: 22%
Roth Account Scenario
By contributing to a Roth account instead of a Traditional retirement account, you forgo the tax savings of $576 each year. After 8 years you move into the next tax bracket of 22% and decide to stop Roth contributions. Your investments continue to grow averaging 5% returns. When you retire at 65, your assets have grown to $225,344. None of it is subject to taxes and never will be! Your retirement tax bracket has no impact on these funds. However, you may use these assets in combination with Traditional IRA assets strategically to allow your Traditional assets to be taxed at lower rates potentially.
Traditional IRA or 401(k) Scenario
You reduce your taxes by about $600 each year (rounded to keep clean easy numbers), but in order to maximize this benefit you save those additional funds into your traditional account as well. This allows you to save a total of $450/month. We only want to focus on the first 8 years since we are comparing that tradeoff of to Roth vs. Traditional savings. It is assumed that savings will continue in a traditional account because this individual will be in a greater tax bracket than the 12% assumed in the first 8 years of this strategy. When you retire at age 65 these assets would be $253,513. This account is fully taxable and are subject to the assumed 22% tax rate in retirement. After the tax impact, the true value of the account you receive upon withdrawal to be worth $197,740.
The difference is $27,603 more if you do a Roth contribution! Higher tax rates in retirement or higher annual growth rates would increase this value to be even more substantial.
This was an illustration of Roth contributions, but Roth conversions value is identical. Instead of contributions, you could move $4,800/ year from your IRA account and convet it into your Roth account. The impact would be that you would have to pay $576 in taxes as a result of the conversion.
Checkout: How to Retire Early Strategy Guide
Be Aware of Impacts
How much you are going to pay in income tax is the main factor, but you still have to consider the impact on other parts of your financial life that may be impacted by recognizing higher incomes. A few examples are the following:
- Financial aid eligibility
- Capital gains rate
- Social Security that is taxable
- Medicare surtax
- State income tax (will you potentially move from a state with a higher or lower income taxes?)
- Student loan repayments (if income based)
- Tax credits (Limits and Phaseouts)
- Tax deductions (Limits and Phaseouts)
- Healthcare subsidies
No Longer Reversible
The tax reform at the end of 2017 ushered in a lot of individual and business tax benefits, but one of the few outlier negative impacts was the inability to reverse your Roth conversions. Prior to the new tax reform, you were allowed until tax filing the following year to correct a mistake. This meant that you were not required to be precise or have a detailed plan when it came to conversions. If you ran into any of the above impacts or crossed into a higher bracket than you were expecting you could simply reverse a portion or the full conversion.
Roth Conversions Compared to Roth Contributions
Roth conversions and Roth contributions are treated very differently. First, Roth contributions are easier than Roth conversions. Contributions however are capped at $5,500/year (+$1,000 if 50 or older). Another issue that is slowly changing is that most employers still do not offer Roth 401(k)s. A Roth 401(k) avoids income phaseouts and allows contributions up to $18,500 (+$6,000 if age 50 or older) if you have access to one through your employer. Additionally, some may find themselves phased out of Roth contribution eligibility due to income limits. All of these factors reduce your ability to fund a Roth account during your career, but the great thing about conversions is there is no limit or phaseouts.
Your Roth contributions can easily be removed without any negative tax consequence or penalty, which makes them extremely flexible. Roth conversions are treated differently though, they have a five-year waiting period before you can avoid the 10% penalty of withdrawing the converted amount. In both instances, you want to avoid taking out investment growth that occurred because this too has a 10% penalty unless you are older than 59 ½ or fit one of the limited qualified distribution options.
How Much Should I Convert?
The nice thing about this strategy is that you can decide the value on a year-to-year basis. One of the worst things that someone can do if they have a pretty sizable traditional 401(k) or IRA is convert it all in one-year. This would be a major fail and shoot their tax bracket to an outrageous rate.
Instead evaluate all of the factors I outlined above and decide what you will feel comfortable on. If you determine that your situation will not run into a unique negative impact, then you can find your tax bracket details below for 2018 and determine that rate you are comfortable paying taxes at this year. It is a common tax strategy to fill up your tax bracket. Remember, Roth conversions are no longer reversible so you should wait to pull the trigger until the end of the year.
Find your bracket below.
Common Deductions and Credits
How Much in Roth Should I Have?
This question should also be answered relative to the factors that we covered in this strategy guide. Having a balanced approach to the three main types of tax treatment accounts, is a great strategy. A balanced approach allows you flexibility to navigate your future tax situation with greater control regardless of what the tax brackets look like.
The three types of tax treatment accounts are the following:
- Maybe Taxable: Non-retirement brokerage accounts
- Always Taxable: Traditional IRA, Traditional 401(k), etc.
- Never Taxable: Roth IRA, ROTH 401(k), and HSA Accounts
Why not avoid future taxes altogether and have 100% in Roth? I feel very strongly that you should not have 100% of your retirement assets in Roth. The current U.S. Income Tax Brackets are progressive. This means the first portion of your taxable income is taxed first at 0%, then 10%, 12% and so on. If you believe the U.S. will maintain a progressive tax bracket in the future, then it not horrible to have some always taxable accounts to fill the lower brackets in retirement.
I will not make you follow another elaborate example. Instead, I will do a quick overview:
Eventually many of my clients are taxed between the 22% and 34% tax brackets. It makes sense in these higher brackets to begin to lean more toward deferring taxes with traditional account contributions. If you could defer income when you are at the 24% bracket, but earlier in your career you funded a Roth IRA. Then you may have Roth assets that are tax free to combine with your Traditional account distributions when you retire to keep your effective tax rate below 24%. This quick example shows that it is useful to both types of assets in retirement.
Roth conversions have the potential to save thousands of dollars if used strategically. As you can see, there are a myriad of factors to weigh and consider in order to determine first if you should implement a Roth conversion and if so how much you should convert. I encourage you to work with a financial planner or tax planner to develop your tax strategy. It only takes a a few strategic maneuvers to pay for the value of expert advice. It is even more important due to the lack of ability to reverse Roth conversions.