Roth conversion can be a great tax strategy (since the stock market is down too!)
What is a Roth conversion?
A Roth conversion is the process of transferring funds from a traditional IRA to a Roth IRA.
This conversion is fully taxable (you will pay taxes on the conversion), so it only makes sense to do it under certain conditions.
Quick example
You are 65. You just retired. You have $500,000 in your 401(k), which you just rolled over into a traditional IRA. You also decided to postpone your Social Security benefits.
You use your taxable account to withdraw long-term capital gains and stay in a 0% tax bracket, and also start converting, say, $20,000/yr into a Roth IRA, which will be in a 0–10% tax bracket (assuming no other income).
By the time you are 73, your Required Minimum Distributions (RMDs) will be lower, as you’ve depleted your IRA by ~$160k.
A lower RMD reduces your taxable income in retirement, which could keep you in a lower marginal tax bracket, especially once you have other income sources like Social Security or pensions.
Note: this strategy is helpful even before retirement in certain situations. More on this in a bit.
When is it beneficial to do conversions?
Roth conversions are beneficial when your tax rate on the conversion is less than your tax rate on a later withdrawal.
It all comes down to your marginal rate now vs in the future.
For example, if your current marginal rate is 24%, and your future marginal rate will be 12%, it makes no sense to convert.
In the opposite case, it makes perfect sense to convert.
The question is, how do we estimate these marginal rates?
For the current marginal tax rate, it is often the same as your tax bracket in simple scenarios (i.e. W-2, no dependents, no credits) but not always. If you have the Child Tax Credit, 199A deductions, capital gains/dividends, it’s best to estimate your current marginal tax rate using software or online calculators.
The future one is even more difficult to estimate, as it depends on:
- future tax laws (using current as the baseline is fine)
- your future income projections
For future income, it might look something like this:
This estimation can help you predict your future marginal tax rate to some extent.
Specific situations when Roth conversions are helpful:
- Low tax year/low income
You might find yourself:
- Going back to school full-time
- Taking time off to care for a family member
- Being unemployed (a bit risky though, as you don’t want to use a lot of cash)
- On a sabbatical
Since you are in a low-income year, it makes perfect sense to convert, as your income/marginal tax rate would be minimal. However, make sure that doesn’t impact any tax credits (like the EITC, available to lower-income taxpayers).
- Down markets
For example, say you were going to convert 100 stocks worth $10,000 into a Roth.
Now, because the market is down, you can convert the same 100 stocks (now worth $9,000) into a Roth. This lowers your taxable income while still getting the same number of shares. You could also convert $10,000 worth now, which would be around ~110 shares.
Importantly, a down market doesn’t make the conversion more favorable if your marginal tax rate is too high. In other words, just because it’s a down market doesn’t mean you should convert.
Also, you shouldn’t wait for a market crash to do Roth conversions. If the tax rates make sense – consider it.
- Roth Conversion Ladders
There are people wanting to retire at 40-45.
Roth conversions can actually be helpful in such cases because after you convert from a Traditional IRA to a Roth (and pay income taxes), you start a 5-year period, after which you can withdraw the taxable portion of the conversion without any tax or penalty, even before age 59½ (your non-taxable portion, or contributions, can always be withdrawn at any time without any penalties)
So in a sense, Roth conversions can be a way to access your money early, similar to the Rule of 55 or 72(t) SoSEPP.
The “ladder” strategy means that you can convert some amounts every year, and after the first 5-year period, you can withdraw those conversions every year.
- Before collecting Social Security
If you can postpone SSB (similar to our earlier example) in your retirement and live off savings or capital gains, it could be a good time to convert before those RMDs and SSBs kick in.
- Paying conversion taxes with outside money
Once you convert, you can actually pay taxes with outside money, so that the full amount of the conversion goes in.
Let me give you an example:
$100,000 of conversions will cost, say, ~$25,000 in taxes. Total Roth IRA amount after conversion is $75,000, OR
$100,000 of conversions will cost $25,000 in taxes paid outside of the conversion (i.e via bank withdrawal). Total Roth IRA amount after conversion is $100,000.
In addition, if you pay taxes directly via the conversion, it will be subject to a 10% penalty on the tax portion before age 59½, but that still could be worth it depending on the tax rate.
So, if you do decide to do Roth conversions and can afford the out-of-pocket tax bill, it could be helpful to maximize the value and future growth of your Roth account.
- Saving on state estate taxes
In Oregon, estate taxes kick in after $1M of net worth, since there is a $1M exemption. So if you have more than that, you will pay between a 10–16% tax rate.
Say you have $1.1M of total net wealth (with $1M exempt), and convert $100,000 and pay ~$25,000 in taxes. After the conversion, your total wealth is $1.075M, as you paid $25K in tax.
Well, you also just saved $25K * 10% = $2.5K in state estate taxes, as you shifted your accounts.
Again, just make sure that the marginal rates make sense.
Note: the earlier the conversion (i.e if you are far away from retirement), the riskier the bet, as the future is uncertain. We’ve had historically lower rates (the 28% bracket changed to 25% in the late and then to 22% now).
How do you actually convert? Most brokerages allow online, in-kind conversion. Check your broker’s page for more details.
Overall, Roth conversions are a fascinating topic. This tax arbitrage can save you thousands of dollars. However, be sure to work with qualified advisors to guide you on your specific situation. Don’t just do it without planning.
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See you next Saturday.
MC, CPA