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I’m back to talking about tax planning—before the end of 2019 makes it too late to make a difference! Today’s topic: the what, why, when, and how of a Roth IRA conversion.
For certain people under certain circumstances, a Roth IRA can be an integral part of retirement planning. Like all retirement accounts, Roth accounts have a complicated set of rules covering how to establish them, how to fund them, how to take distributions from them and, ultimately, how to pass them on to heirs. Despite all of that complexity, the benefits of a Roth far outweigh the only real negative, which is that you have to pay tax on the dollars you contribute before you invest them in the Roth. What are the positives? Like a traditional IRA, all income in the Roth is tax-deferred. Plus, unlike a traditional IRA, the owner never needs to take distributions, and qualified withdrawals are not taxed.
So why isn’t everyone using a Roth? One reason is that annual contributions to a Roth are limited (annual income can’t exceed between $122K and $137K for single filers and $193K to $203K for joint filers), so many middle-class families are shut out. However, there are strategies that allow you to “Roth” your retirement money today to gain greater benefits in the future. A Roth conversion lets you take money out of your traditional IRA, convert dollars from it into a Roth, pay tax on the converted amount, and then never pay tax again. And for those who are still employed, it gets even better with what’s called a “backdoor” Roth.
Now is a fantastic time to take advantage of these strategies if you can. Why? In short, because the Tax Cuts and Jobs Act has reduced tax rates to historically low levels. Income tax rates in 2019 range from 10% to 37%, and capital gains tax is currently between 0% and 20%. That means that unless your taxable income is greater than $321,400 married or $204,100 single, your highest Federal tax rate will be just 24%. Even if your income is higher than that, your taxable income has to exceed $612,350 married or $510,300 single to land you in the highest bracket of 37%.
A look at tax rates over the past few decades makes it clear that we’re in tax heaven at the moment! In 2000, the highest tax rate was 39.6%—and that was for anyone with taxable income over $288,350, married or single. In 1986, an income of $175,250 married or $88,270 single would have put you in the highest tax bracket at 50%. And from 1965 to 1981, the highest tax bracket was a whopping 70%! From a tax perspective, that means one thing: you’re probably better off paying taxes on as much as you can now.
I have a host of examples of clients whose Roth conversions made great dollars and sense:
- When Maria and Joe moved from CA to Texas, they had a couple hundred thousand in their IRAs. The move allowed them to convert those balances state-tax free! Yes, they paid Federal taxes, but that was long ago when their new Roth was much less valuable than it is today.
- When Mike left his former employer, he left his 401(k) balance invested in the company plan. As a result, he had no IRA money. For the past ten years, we’ve been doing backdoor Roth conversions, contributing to a non-deductible IRA to create a “cost basis” and then converting the IRA to a Roth where there is no taxable gain or loss. That makes the conversion effectively tax-free. Today, Mike’s Roth account is growing nicely into a valuable, tax-free asset for retirement.
- When Don married a higher-earning spouse, his tax bracket jumped from a relatively low tax bracket to the highest bracket. Before he said “I do,” we took the opportunity to convert his entire IRA balance to a Roth—and to pay taxes on the account at a rate he’d never see again!
- When Laura retired at age 66, she delayed her social security until age 70. That gave her almost no taxable income during the interim three-year period. It was the perfect time to annually convert dollars to a Roth at a low 12% tax bracket—a bracket that will vanish for good once she begins to collect Social Security and take her RMDs in her 70th year.