As you enter the 10-15 year period before retirement, some seemingly minor tactics taken today can pay off big for the future. One such tactic is the Roth conversion. See below:
What is a Roth conversion?
Roth conversions are essentially a way of paying some taxes today instead of tomorrow. You basically take out a piece of your IRA, pay the taxes, and roll that portion over to a Roth IRA. Keep in mind you have 60 days to complete the rollover portion – lest you be subject to a 10% penalty. This may sound counterintuitive since you may be in a lower tax bracket once you retire, but a lot of folks forget that RMD’s are a thing.
Quick refresher on RMD’s: It’s Uncle Sam’s way of getting his share for letting you defer taxes on your retirement accounts. They kick in at age 72, at which point you’ll be asked to take out a percentage of the retirement account and pay taxes on it.
As your nest egg continues to grow, it’s likely the value of your IRA has grown as well – potentially making your future RMD (and potential taxes due) sizable. By converting part of your IRA to a Roth, you are creating a tax free income source for retirement.
When should you do a Roth conversion?
Ideally, you’d spread out the number of Roth conversions over several years. For a lot of retirees who are in a lower tax bracket in retirement (since they’re no longer collecting a salary and have substantially lower income), it’s the sweet spot.
Say you retire at 65 and have no other sources of income. In the seven years between your retirement and age 72, your tax bracket tends to be “U-shaped” – reaching a peak right before you retire, falling off a cliff once you stop working, and picking up once those RMD’s kick in. Periodically doing partial Roth conversions each year you are in the bottom of the “U” allows you to pay those taxes little by little (and at a lower tax bracket) rather than doing it all at once.
Even if you’re not retired it could still make sense. Keep in mind that as you’ve diversified your net worth, you are likely to have different sources of income in retirement.
That rental property you purchased that kicks off rental income?
The annuity you’ve purchased to replace an income stream once you retire?
The bond interest in your taxable investment account?
Yup, they all get counted as ordinary income. Unless you plan on doing away with one or several of those income streams, your future tax bracket may not be so low.
Don’t blow your budget
There is a natural budget to how much you should convert – and that’s generally limited to the amount of income left in your tax bracket.
For example, if you’re a single head of household and your take home pay is between $163,301 to $207,350 in 2020, according to the IRS you’d be in the 32% federal tax bracket. If your take home pay for the year is at an even $200,000 – your limit is$7,350. If you mistakenly convert $8,000, you’d put yourself in the 35% tax bracket and potentially nullify any benefit of the conversion.
Always confirm with your tax professional how much wiggle room you have in your tax bracket before considering a Roth conversion.
As I explain in my whitepaper, let’s agree to pay every cent we owe Uncle Sam but let’s not leave him a tip.