Year-end Topics: Roth Conversions

Roth conversions are one of those planning ideas that make a lot of sense on paper. You take money that’s currently in a regular retirement account like an IRA or 401(k), stick it in your Roth and then viola, it turns into tax free money! Sounds great, right? The problem is that several things have to happen first, such as paying a big tax bill. Nobody likes paying taxes and paying them in advance just cuts against the grain for most people, so that’s usually where the conversation stops.

But since it’s still a great planning idea when used correctly, let’s review some of the situations where it makes sense to convert retirement money to a Roth.

Low income now, high income later – Say you’re retiring at 60 and your Full Retirement Age for Social Security is 67. You’ve planned well and want to live off your non-retirement savings (brokerage accounts, cash at the bank, etc) between now and then while letting your retirement money sit. Since you’re not starting Social Security yet, your only taxable income is from interest and dividends in your brokerage account. Your lifestyle remains the same but on paper your taxable income drops off a cliff.

If you’ve been used to paying taxes on $100K per year of income but now interest and dividends is, say, $15K, you have room to convert the other $85K and stay within what you’re used to paying in taxes. You could even do Roth conversions every year until starting Social Security.

Why would you want to do this? Wouldn’t it be nicer to have an extremely low tax bill for a while? Yes, but the looming issue is that your tax bill would rise once Social Security income starts, and then would rise again a few years later when Required Minimum Distributions (which is taxable) kick in. Roth money isn’t subject to an RMD, so making conversions now when taxable income is lower helps smooth out taxes over time. Depending on account balances, you could convert your regular retirement accounts all the way to $0 and eliminate future RMDs altogether.

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Other reasons to convert…

An extension of the example above comes from our retiree not yet being enrolled in Medicare and currently getting a subsidy to buy health insurance on the state exchange. If their income drops too low in a tax year, they could find themselves off their current healthcare plan and on Medi-Cal, with different doctors and a host of other potential issues. Yes, doing Roth conversions means paying more taxes, but it’s probably less than the premiums they would pay without a subsidy until Medicare kicks in at age 65. So, Roth conversions used to “manufacture” income can help here too.

Prepaying taxes for heirs – Since distributions from a Roth IRA are tax free, it’s great to inherit one. Yes, folks who inherit will have to take RMDs from a Roth (the rules are different when you inherit versus when it’s your own account), but the distributions won’t be taxable. This allows an altruistic person to pre-pay taxes for their heirs.

Big losses in a tax year – Maybe you suffered a catastrophic loss to your home, business, or an investment that will dramatically lower your taxable income for the year. If so, you could backfill that decline with a Roth conversion. This is the kind of silver lining that could only make an accountant or financial planner excited, but it’s still something to consider if you find yourself in a bad financial situation.

Once you’ve made the decision, the conversion process is pretty simple and can be done by moving cash between accounts or even the investments themselves. As such, the conversion likely won’t cost anything other than what you’ll pay in tax.

I’m skeptical of the “investment” rationale behind Roth conversions. Yes, there’s marginal benefit that increases the longer you have until retirement. But unless you firmly believe taxes will rise in the future and want to prepay now, it’s hard to square the circle, so to speak.

In other words, I look for specific scenarios before recommending conversions. It simply adds too much in taxes to make it pencil out well over time. It’s far better to get money into a Roth in the first place, either through a plan at work or contributing to your own Roth over time.

Have questions? Ask me. I can help. ​

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