When and Why You Might Consider a Strategic Roth Conversion

Over the past year, have you asked yourself, “How are we ever going to pay for the national debt that has been accumulated under the stewardship of both parties?” I know some of you were asking that question even before the pandemic. The federal government has been running annual deficits since 2002, with the additional red ink in 2020 tallying the total up to more than $3 trillion.

So, where do we go from here? The federal government’s remedies include higher taxes, lower expenses, or both. Those people on the right side of the political spectrum may say no higher taxes but cut spending, and those on the left will switch that around. So, if our elected representatives compromise, we are likely to have a mix of both.

Why a Roth? Because Taxes Are Low Until 2026

With higher taxes potentially coming down the road, it could be worth considering a strategic Roth conversion over the next few years. I will also remind you that the tax reform passed by Congress in 2017 reduced marginal tax brackets, but included a sunset clause that would revert brackets to 2017 levels in 2026 in the absence of action by Congress. If that happens, people now in the 12% bracket will revert back to the 15% bracket, and those in the 22% to the 25%, and so forth. Relative to history, we are in a low tax environment today. With the aforementioned deficits, a reversion to tax averages MIGHT be in the cards.

So, consider a Roth IRA. The contributions/conversions into a Roth go in after tax, and grow tax-free forever. If an investor structures a strategic Roth conversion plan, they move (convert) dollars from a pretax plan (i.e., traditional IRA, pretax 401(k), etc.). This conversion triggers a taxable event. If you convert $50,000 from a traditional IRA to a Roth, you add $50,000 of income to your tax return that year. Many people understandably recoil at this because of the tax bill. It is undoubtedly short-term tax burden, but that must be weighed against the long-term tax gain of having the Roth dollars grow tax-free.

How My Client Pulled Off His Roth Conversion Coup

Case and point, some years back, a client of mine retired at age 64. He was concerned by all of his pretax investments, for which he would need to begin taking distributions from to satisfy IRA required minimum distributions (RMDs) at age 70 (since changed to age 72). He knew that with RMDs, he would likely be in a higher tax bracket for the rest of his life.

So, he carefully planned how much “room” he had in his current tax bracket — before bumping up into the next higher bracket — and “filled” it with a Roth conversion. He converted $50,000 yearly for four years and recognized the need to pay that tax bill with savings as opposed to having taxes withheld from the converted amount. He faced a substantial tax bill but now has a substantial tax-free Roth account that has absolutely no RMDs. And since his pretax portfolio is $200,000 less due to the conversions, his future RMDs will also be less.

Clearly, the foundation for this concept rests with a projection of your future retirement income and a guess at where taxes are headed. If you are facing a higher tax bracket years down the road due to RMDs, a strategic Roth conversion may make sense.  If you don’t foresee your income going UP in retirement, but you believe taxes are going up for individuals, then the Roth conversion concept might be compelling. Conversely, this may be less compelling for those who expect to be in a lower tax bracket in the future or if they expect taxes to decrease in the future.

Another Client Capitalized on a Market Downturn

Another timely example took place in March 2020. A client of mine recognized that his traditional IRA was severely depressed as the pandemic took hold. He wisely converted a chunk of that IRA to his Roth. This was because stocks were depressed, and he converted more shares for the same dollar amount he desired to convert. When the market recovered, those shares he converted to the Roth rose along with the market.

A few key things to remember for converted dollars to a Roth: Generally, the dollars converted to a Roth must stay in the Roth for five years to avoid penalties and taxes. In addition, if you do conversions at or beyond age 72, the RMD must come out before the conversion, nor are RMDs eligible for Roth conversions.

This may all seem disturbingly complex, which it certainly is. Think through all concepts, and consider seeking advice from a professional to corroborate your plan.