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).
Roth Conversions are best for those who:
Caveats to keep in mind:
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…
AdamCategories: Adam Koos, CFP®, CMT®, Educational Articles