During these turbulent times, Benjamin Franklin’s famous idiom in his letter to Jean-Baptist Le Roy rings true, “…but in this world, nothing can be said to be certain, except death and taxes.” While taxes may be inevitable, there are some strategies that can be implemented that will prevent filing your returns from feeling like a do-it-yourself mugging. We’re not going to touch on the complicated and convoluted tax strategies of the uber-wealthy, there’s something much simpler that’s certainly worth considering and likely worth doing- a Roth conversion.
In short, a Roth conversion is when you elect to voluntarily pay taxes by moving retirement savings from a pre-tax to a post-tax account. Think of it as electing to pay taxes on the cost of your seeds rather than being taxed on the value of your crops. You’re paying taxes now so that your retirement account can grow entirely tax-free going forward. If adding the full value of your retirement account to your taxable income for the year isn’t palatable, fear not, you’re able to strategically convert your pre-tax assets to your tax-free account over a period of time. While there’s no shortage of investment “rules of thumb”, the Roth conversion decision should be based on your particular set of circumstances.
Whether or not you elect to convert all or a portion of your retirement savings to a Roth account typically hinges upon the following criteria:
When will you need the money? There’s little sense in converting to a Roth if you don’t intend on allowing the money to grow tax-free. The Roth IRA also has a required 5-year aging period. There isn’t any limitation on your ability to buy and sell investments but to qualify for a tax-free distribution, you must be at least 59.5 years old and have had the account funded for at least 5 years. Many people don’t elect to convert because they perceive themselves to be “too close to retiring.” It’s important to consider that just because you’re approaching retirement doesn’t mean that a conversion wouldn’t be advantageous. In most cases, our clients aren’t withdrawing their IRA in a lump sum. There’s often an opportunity for your Roth IRA to appreciate in value in retirement, especially when you consider that Roth IRAs are exempt from IRS-mandated withdrawals.
What will your tax bracket be in retirement? The old school of thought was that it was best to contribute to a traditional IRA to take advantage of tax-deductible contributions during your earning years before taking distributions in retirement, presumably at a lower tax rate. The problem with this theory, particularly for those who have saved and invested wisely through a self-directed IRA, is that they may have an equal or greater income in retirement than they did while fully employed. It’s wise to consider all of your potential future sources of income before pulling the trigger on a conversion. The second element that requires some forecasting is what tax brackets will look like by the time you retire. It’s a rare occasion that I speak to anyone who anticipates them to be significantly lower than they are today.
Can you afford to pay for the conversion? Any cash or investment converted to a Roth will affect your taxable income for the year in which the conversion occurred. Important factors such as your current income and ability to pay the tax bill will affect your decision of whether to convert. Many savvy investors will reverse-engineer this transaction and determine how much they’re able to convert without bumping themselves into the next tax bracket and then subsequently based on their ability to pay the tax liability.
Has anything occurred this year that makes a full or partial conversion more compelling? Has your income been less than in previous years? Have you invested in a rehab property and wish to convert before the value is significantly higher? Do you own a type of fund that has shown a reduction in value that you believe will appreciate significantly in the future? Have you made an investment outside of your IRA that has reduced your taxable income for the year? Do you own investments that you expect to provide a long-term income stream that you’d prefer to collect tax-free? Do you have a high amount of cash but are unsure about making an additional investment? It might be prudent to use that cash to cover the IRS bill for the conversion.
While voluntarily electing to pay more in taxes doesn’t seem particularly palatable, there’s a myriad of reasons that can make converting a smart long-term move that allows you to enjoy more of your hard-earned savings. Converting means being smart about the inevitable in order to enjoy the freedom of tax-free growth going forward.
