Coach’s Corner – “How to Reduce Your Tax Bill in 2021 and Beyond”

With a change in regime in Washington D.C., it is widely expected, at least at some point in the next four years, that income tax rates will likely rise.  With this expectation comes the need to re-evaluate our tax planning, and as we examine strategies that might help mitigate or reduce our tax bill in the future, we turn to the unique concept of a Roth IRA Conversion.

 

As an FYI – for those of you who would rather watch or listen, you can CLICK HERE to check out last week’s CA$H Podcast on this very same topic.

 

How does it work?

A Roth IRA Conversion is the process of converting a pre-tax asset (such as a 401k, 403b, 457 Deferred Comp plan, TSP, DROP, PLOP, or Traditional IRA) to an after-tax, tax-deferred Roth IRA.  Once converted, the Roth IRA can grow, tax-deferred, and qualifies for tax-free withdrawals at retirement.  What’s the catch?  Well… you have to pay the tax, at your income tax rate, in the year on the conversion, of course.

 

How does it help me reduce my tax bill?

By paying tax on the pre-tax asset now (when tax rates are relatively low), the newly converted after-tax money can grow tax-deferred and withdrawals can be taken tax-free, when income tax brackets in the U.S. could be higher.  This can be especially beneficial if conversion takes place in year(s) when your income is exceptionally low, which means you either pay less tax in the year of the conversion – or you can convert a higher dollar amount in that year.

 

One thing you have to watch out for is not converting so much of the pre-tax assets that the conversion pushes your income tax bracket up to levels that would not be surpassed in the future (i.e. – strategically converting by dollar amount to maximize the strategy).

 

Common myths:

  1. Roth Conversions are great for everyone:  Mehhh… not so fast.  Often times, Roth Conversions are used as marketing tools to acquire new clients.  It’s not the easiest concept to understand, and it might not make any sense for you at all, so be careful when being lured in and ensure you’re getting a comprehensive analysis performed before converting anything at all!

 

  1. When implementing a conversion, just use the pre-tax assets being converted to pay the tax:  In a perfect world, you would use other, after-tax money to pay the tax (such as a savings or checking account, maturing CD’s, or a joint investment account).  Using the account being converted to pay the tax only reduces the value of the account, rendering the strategy much less valuable in the end.

 

  1. Roth Conversions result in tax savings for all those who implement them:  Blanket advice is rarely good advice.  This strategy can make a lot of sense for the right people, at the right age, with the right mix of assets (pre and post-tax), but it most certainly isn’t for everyone.  If you’re not careful, it’s possible to implement a Roth Conversion and pay more tax in the long-run… the opposite of what we’re trying to accomplish here!

 

Roth Conversions are best for those who:

  • Are soon-to-be retired, recently retired, or at least partially retired.
  • Have pre-tax assets to convert (401k’s, IRA’s, 403b’s, 457’s, Deferred Comp, TSP, PLOP, DROP, etc.).
  • Worry about paying higher taxes later in life
  • Worry about passing assets that have never been taxed onto their kids, who will then have to pay the tax on the inheritance over 10 years or less (assuming beneficiaries are set up correctly).
  • Have non-qualified assets to pay the tax on a conversion (this is crucial, in my opinion).

 

Caveats to keep in mind:

  • Always remember, you have to pay the tax on any conversion that is made, in any year!
  • Of course, when you implement a Roth Conversion, it’s always best to do so in years when your tax rate is relatively low.
  • If you use the pre-tax asset to pay the tax, you can render the entire strategy worthless!
  • If you are under 65 years of age, you might need to keep in mind tax credits for the ACA (Affordable Care Act) prior to affecting a Roth Conversion.
  • On the other hand, if you’re 65 or older, we need to keep in mind Medicare Part-B premiums when converting.

 

Is a Roth Conversion Right for You?

When determining if it makes sense for any client of ours, we implement a Roth Conversion Analysis using your tax and income inputs in order to determine how much (if any) makes sense to convert.  If it does make sense, we can project how much to convert (and when), in order to maximize the benefit of this strategy.

 

We then work together with either your CPA – or a CPA on our team – to complete the analysis and get the blessing of a tax professional before moving forward and making it official.  Once the analysis is complete, if a conversion does make sense, we can help you execute the strategy (which can be implemented over one, or several years).

 

In the end, a Roth Conversion can save you a lot of income tax paid over the years.  It can also help us to create tax-free income for your spouse and heirs when building a multi-generational legacy plan in conjunction with your estate plan.  Whether it makes sense or not has everything to do with your personal situation, so let us know if we can help!

 

Till next time…

Adam

Categories: Adam Koos, CFP®, CMT®, Educational Articles

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