Roth conversions are a powerful vehicle to minimize future taxes. But not a lot of people understand why or when they are helpful, so let me break it down.
How conversions work:
You can convert your traditional IRA (including a traditional 401(k) that you roll into an IRA), which is tax-deferred (pay taxes later), into a Roth IRA, a tax-free account.
For example, if you convert $10,000 from a Traditional IRA into a Roth IRA, your funds will be able to be withdrawn tax-free and penalty-free after 5 years and after age 59½.
The $10,000, though, is going to be taxed, so the goal is to time these conversions strategically during low tax rate periods.
Example
Say from age 25 to 50, you have been contributing to a traditional 401(k). Assuming your federal tax rate was 22%, you have been receiving a 22% tax deduction on every single dollar you contributed. For every $1,000 you contributed, you deferred $220 in taxes.
Now, let’s say you are 50, single, and are looking to retire. You’ve done well financially, invested in a taxable brokerage account and a pre-tax 401(k). You decide to quit your job and roll over the 401(k) into a traditional IRA (no tax impact, direct rollover).
You sell $70,000 worth of stocks from your taxable brokerage account, which had a cost basis of $20,000. So the taxable gain is $50,000.
Additionally, you convert $15,000 from a traditional IRA to a Roth IRA by transferring the shares directly from the IRA to the Roth. This $15,000 is considered income on the tax return, but here’s the important part…
Your sale of long-term stocks in a brokerage account is not taxable because long-term capital gains are taxed at 0% if your total taxable income stays below $49,450. In this case, we have $50,000 of gains + $15,000 from the IRA conversion – the $16,100 standard deduction = $48,900.
The standard deduction offsets the $15,000 Roth conversion (ordinary income), effectively reducing it to $0. That means all of the remaining taxable income is long-term capital gains, which still falls under the 0% bracket.
So, we took a $15,000 tax deduction (worth $3,300 of tax savings) when you were contributing to your 401(k) back in the day, and were able to convert to a Roth with no tax impact because you managed your tax brackets strategically. Also, you still have $70,000 of cash to live off.
More examples
Roth conversions are most beneficial during low-income tax years.
For example, if you went back for a Master’s program and didn’t earn much, or if you decided to take a break from work for a year, or if you are in a low tax bracket (e.g., you have been contributing to a 401(k), receiving a 22% tax deduction, and are now in the 10% marginal bracket).
The main value proposition for a lot of people is to do Roth conversions during the following scenarios:
- Before pension income hits
- Before Required Minimum Distributions (RMDs) for a 401(k)/traditional IRA
- Before Social Security
- If you can use a brokerage account to live off
But you still have to make sure that the tax rates make sense.
For example, say once you turn 62, with your pension, Social Security, and other sources, you will be in the 24% tax rate. But say from 55 to 62, you may be in the 10-12% tax rate.
The goal would be to convert as much as you can, at least within the maximum 12% tax bracket, since you know you will be higher in the future. This conversion can also help you lower your future RMDs (because it lowers the tax-deferred account balance).
I hope you learned something new.