Food for Thought this Thanksgiving Week: Roth Conversions

Food for Thought this Thanksgiving Week:  Roth Conversions

Should you find yourself with some thinking time over the next week beyond the time gratefully spent with family, friends, food and football, the conversion discussion that follows may provide “food for thought” as a welcome break from more eating! The discussion? Roth Conversions.

Chances are you know about Roth IRAs (or have at least heard of them) and what makes them special (see tables below). Perhaps you've also seen calculators which purport to tell you whether it makes sense to convert traditional IRA funds into Roth IRA dollars. The calculators compare the taxes you would pay now for the conversion versus the taxes you would pay in the future when taking IRA distributions. The reasonable conclusion seems to be: if you expect your marginal tax rate to be the same or lower in retirement, the conversion (and, the taxes you’d pay) doesn't make sense – better to pay less tax later. Pretty straight forward.

Not so fast, however. There are other factors to consider. First up, your marginal tax rate is only a part of what you’d pay to convert today. A taxpayer in the 39.6% marginal bracket also faces the 3.8% Medicare surtax and the phase-out on itemized deductions and personal exemptions as well. And, if you live in a state with an income tax, that number is higher still.

Another consideration is weighing the cost (now and later) of the flexibility you may derive when a portion of your retirement money is available tax-free. Let’s say you’ve been a good saver, loaded up your Traditional IRA accounts, and essentially did everything right. You approach the age of 70 1/2 - the year in which Required Minimum Distributions (RMDs) must begin for the money you’ve accumulated or rolled into your traditional IRA. [Note that Roth IRAs do not have an RMD]. As you begin taking the required distributions, you may find that these distributions push you into a higher tax bracket than you may have previously considered. In addition to the higher income tax, you may face some of other tax implications previously described. If that’s not enough, there is also the potential of your Social Security being taxed at a higher rate and your Medicare Part B premiums being pushed higher as well.

Recognize though that if some of your money were in a Roth account, you have more flexibility in meeting your retirement income needs. In each retirement year, you can take money out of the traditional IRA up to a certain tax rate--say 15% or 25% (meeting your RMD, of course), before the surtax is triggered and before all your deductions/exemptions are phased out. Should you need or want more income, you can then take the remainder out of the Roth account tax-free. This gives you more control of your tax rate each year – we call it ‘bracket management.’

Similarly, if your income fluctuates, you may choose a year when your income is low to make a larger Roth conversion, not wasting the capacity in the lower bracket. You would likely skip the conversions during years when your income returns to normal (higher) levels.

The point is that determining whether or not to convert some of your IRA into Roth dollars is NOT simple – and, not always calculator-friendly. It clearly doesn't make sense to make a conversion if it will bump you up from a 25% rate to 39.6% on this year's tax return, and trigger stealth taxes. However, someone in the 25% bracket could make a partial Roth conversion that would use up the rest of the 25% bracket, and perhaps even bump up to the very top of the 28% rate with a somewhat larger conversion--taking advantage of the lower rate while still keeping income under the various tax thresholds. Part of the analysis requires you to look ten to fifteen years down the road instead of one or two – the number of years frequently considered when doing tax planning.

Working through the options is often best done during a joint meeting with your CPA and financial advisor. We are about to launch into a series of such tax planning meetings with our clients. As you know, many of the tax deadline dates are April 15th, however, the Roth conversion deadline in any year is December 31st. Where possible and practical, we like to see our clients accumulate three categories of money (taxable, tax-deferred and tax-free) to allow them to configure their income in later years. Deciding how, at what cost, and when to add to the Roth bucket is one of the many considerations we review during these tax-planning, strategy meetings.

One last note: there is a fair amount of confusion regarding Roth IRAs and contributions rules versus Roth 401(k) contributions. They are different vehicles with different rules. In a nutshell, however, the Roth 401(k) is another way to accumulate money in the “Roth bucket” but the analysis should be considered separately from Roth conversion analysis.