An all to common scenario in our office is, Client A walks in, has done an excellent job of saving money, presumably enough money to retire on, yet it’s all in tax deferred, retirement vehicles that certainly have their many benefits but all too soon, this client, will begin to have to deal with the dreaded Required Minimum Distributions (at current law, age 72) and at some point those RMD’s look to become more than the client wants or needs, therefore forcing taxes on an asset that would be better to be left to a tax favored account.
This is where Roth conversions earlier in your retirement lifecycle (either pre or post retirement) can make a lot of sense for the right person. Roth conversions are the process of taking pre-tax money, which could be money in your Traditional IRA, 401(k) or another pre-tax asset and moving (converting) it to your Roth IRA. This requires you paying tax today, but once in the Roth your money will start growing tax free, will be distributed tax free and there will be no Required Minimum Distributions in the future.
There are a few common planning ideas around Roth conversions:
The 12% Roth Conversion
For those that are in the 12% tax bracket considering utilizing the rest of this bracket to complete your Roth conversions. For a married couple, the 12% federal income tax rate goes all the way up to $81,050. With a standard deduction of $25,100 that couple could earn up to $106,150 and remain in the 12% bracket. Once you go above this taxable income level the rate jumps to 22%. For non-married individuals the 12% federal income tax rate goes up to $40,525 with a standard deduction of $12,550. This means a single individual could have taxable income of up to $53,075 and still remain in the 12% bracket.
Let’s say a couple’s income was going to be $75,000. With the standard deduction ($25,100) they would only pay taxes on $49,900 therefore leaving them up to $25,100 to convert to their Roth IRA while staying in the 12% bracket. If they choose to convert the entire $25,100 pushing them to the top of the 12% bracket, this would cost them $3,012 in federal income taxes. If the $3,012 tax price tag was too expensive, they could consider converting a smaller amount that would still be in the 12% tax bracket and would fit their budget.
Below are examples of client’s scenarios we’ve been able to utilize the 12% tax bracket strategy:
When one spouse decides to leave the workforce for a few years to care for young children or an aging parent. This provides an income drop that allows the client to now utilize the remaining 12% bracket for Roth conversions.
One spouse may retire before the other because of age differences or job stress level situations. This provides the drop in income for a few years needed to maximize the 12% bracket.
When a client retires, they may see a drop in their taxable income. While time is not on your side anymore there may be situations where a Roth conversion at the 12% bracket makes sense to reduce future RMD’s, that may force you into the higher brackets.
Fill Out the Bracket
Another idea that is common in the financial planning world is the fill out the bracket that your currently in. While this can certainly be a little costlier for high income earners, it may be prudent to explore what tax bracket you are currently in and determine if you should pursue a Roth conversion to the top of that bracket. The federal brackets today are 10%, 12%, 22%, 24%, 32%, 35% and 37%. Your decision to fill out your bracket with a Roth conversion may partly depend on your thoughts around where tax rates will be in the future but if you’re like me, you’ve got to believe they’ll be going higher over time.
Stock Market Drop? Convert
Last year during the height of the COVID-19 pandemic the stock market dropped over 30% at its worst. Later in the year, the market fully recovered and the S&P 500 ended the year up 18.40%. When the market dropped it provided a unique window for clients to do Roth conversions and have all the recovery happen inside of the Roth IRA. For example, an asset that was worth $10,000 may have dropped to $7,000. If the $7,000 was converted, you would owe tax on the $7,000 conversion. If the money was subsequently reinvested when it was converted the asset would have reaped all the recovery and subsequent growth inside of your Roth IRA.
Get a Tax Pro
As we constantly mention to our clients, please consult with your local tax professional. It’s well worth the cost to ensure you don’t make mistakes on a Roth conversion. The advisors of Whitaker-Myers Wealth Managers are happy to discuss your personal situation to determine if a Roth conversion may make sense for you.