I have no idea who originally said it, but we have all heard the line, "there are only two things in life that are certain: death and taxes." While there is nothing we can do about death, there are fortunately some strategies we can employ to manage or, in some cases even, completely eliminate future tax liabilities. One of the key tools used to employ such a strategy is the Roth IRA.
Roth IRAs Are Different From Traditional IRAs
A traditional IRA is funded with pre-tax dollars that are allowed to grow tax-free until they are withdrawn. When traditional IRA funds are withdrawn, the total amount of the withdrawal is included as income in the year taken and taxed at your personal marginal income tax rates. Traditional IRAs are also subject to required minimum distributions (RMDs) once an individual turns 72, whether the person is retired or not. For individuals who need the total amount of their RMD to support living expenses, RMDs do not present an issue. RMDs do however present an issue for individuals who do not need the total amount of their RMD to support their living expenses but are forced to withdraw the money and pay taxes on it anyway.
Many people never contribute directly to a traditional IRA but end up with IRA assets anyway. This happens when people contribute to their employer-sponsored 401(k) or 403(b) while working to take advantage of company matching benefits and pre-tax investment compounding identical to the benefit within a traditional IRA. When people retire, they typically roll over their 401(k) or 403(b) to an IRA. A rollover IRA is the same as a traditional IRA when it comes to taxation and RMD requirements. The only real distinction between a traditional IRA and a rollover IRA is in how the IRA was initially funded.
A Roth IRA is distinctly different from a traditional (or rollover) IRA because of the account type's unique taxation characteristics. A Roth IRA is funded with after-tax dollars but allows investments to grow tax-free without further taxation when withdrawn. When Roth IRA funds are withdrawn, they are not included in your income for tax calculation purposes. It is like taking after-tax money from your savings account. Additionally, Roth IRA's are not subject to required minimum distributions.
Roth IRA Conversions
The Roth IRA becomes a powerful tool when used within the context of a properly constructed Roth IRA conversion strategy. During working years, many people focus on trying to maximize their funding to employer-sponsored plans. By the time they have enough income to do so, they often find they are phased out of being able to contribute any excess savings to Roth IRAs given Adjusted Gross Income limits of $125,000 if single and $198,000 for couples. So how then can a person fund a Roth IRA? This is where a Roth IRA conversion comes into play. There is often a lot of confusion when it comes to Roth IRA conversions. Many think they are ineligible to fund a Roth IRA based on earned income limitations or being phased out by their income level. While this is true when it comes to contributing to a Roth IRA, there are no limitations when it comes to converting traditional (or rollover) IRA assets to a Roth IRA.
Any amount of IRA assets can be converted to a Roth IRA in any year, so long as you recognize the withdrawal amount as income in the year withdrawn and pay taxes according to your marginal income tax levels. Determining how much and when to convert (if any) lies at the heart of constructing a proper Roth IRA conversion strategy. The analysis is based on a number of factors and is sensitive to a person's unique situation.
Tax Rates Are Increasing
One such factor aiding the math for many is that today's lower marginal income tax rates under the Tax Cut and Jobs Act are set to expire in 2026. At expiration, marginal tax rates are set to revert to the previous higher levels. The difference in personal marginal income tax rates and income thresholds is substantial as can be seen from comparing the charts below:
Many individuals today stand to benefit from a strategy of converting IRA assets in 2021, 2022, 2023, 2024, and 2025, realizing income up to some specified marginal bracket and paying taxes each year. By converting some amount of IRA assets and realizing some amount of income each year, the individual can pay income taxes based on the current lower income tax rates and avoid having to realize the income after 2025 at higher income tax rates.
Benefits of a Roth IRA Conversion Strategy
Aside from the obvious benefit of paying income taxes now while personal marginal income tax rates are lower than paying them later when rates are higher, there are several less obvious benefits to a Roth IRA conversion strategy as well. For beginners, having assets invested in a Roth IRA in addition to an IRA allows you to coordinate withdrawals later to keep yourself just under your highest marginal income tax bracket. For example (ignoring exemptions and other income), assume in 2026 you needed $100,000 from your IRA to help fund your living expenses. Your marginal income tax rate would be 25% if married filed jointly. You would pay 10% on your first $18,650, then 15% on the next $57,250, and finally 25% on your last $24,100. Altogether, your tax bill would be $16,478. But say you funded that last $24,100 from your Roth IRA instead of your traditional IRA, you would reduce your tax bill by 37% and save $6,025. Having sufficient assets in a Roth IRA allows you to create an optimal tax-efficient strategy of ongoing withdrawal coordination to minimize the amount of taxes you pay over your lifetime.
Another less obvious benefit of a properly constructed Roth IRA conversion strategy is that you can lower the amount of your RMD. You can do this by converting your IRA assets to a Roth IRA, reducing the amount of assets left in your traditional IRA accounts that are subject to RMD rules. By lowering the amount of assets in your traditional IRA, you can lower your RMD to a level such that you do not have to recognize income and pay taxes on money that is not needed.
Lastly, a Roth IRA conversion strategy can also be used to pass more wealth on to beneficiaries in a tax-efficient way. If you were to leave your traditional IRA assets to your beneficiaries, they would have to withdraw the assets within ten years of your date of death and pay income taxes on the amounts withdrawn in the years taken. There might be two problems with this. First, your beneficiaries might be in a higher marginal income tax bracket than you are given they are still in their working years. Second, your beneficiaries will have to pay taxes on the ten years of capital growth on the assets. If your beneficiaries are in higher marginal income tax brackets than you, paying taxes at your lower rate to convert the assets to a Roth IRA allows the assets to pass and not be taxed at your beneficiaries' higher tax rate later. Additionally, the assets can grow tax-free for ten years before your beneficiaries must withdraw the assets. The end result could be additional material wealth being passed to your beneficiaries.
When to Start Planning a Roth IRA Conversion Strategy
One of the reasons conventional wisdom is to start retirement planning at least five years before your planned retirement age is to allow time to develop and take advantage of strategies such as creating a Roth IRA conversion strategy. Time is your friend when planning for retirement. While a Roth IRA conversion strategy may always make sense for some people in certain circumstances, today's lower Tax Cut and Jobs Act personal marginal income tax rates in place until 2026 create a particularly attractive opportunity for many. Another time the strategy may become particularly attractive is just before retirement if you have a year or two of low realized income between leaving work and beginning retirement. Filling in those lower marginal income tax rate brackets by converting can be beneficial. Lastly, the first few years into retirement can also be an opportunity for some. Typically speaking, the longer the time period the Roth IRA assets have to grow, the sweeter the math becomes.
While a Roth IRA conversion is an important strategy when it comes to managing your taxes, it is not the only one. Read our Insight entitled, "Strategies to Manage Taxes in Retirement" to learn more about other tax management strategies.
If you are ready to begin planning for retirement and would like to explore potential Roth IRA conversion strategies, we are the people to help you. Click on the Contact button below to get in touch with us.
ABOUT THRIVE RETIREMENT SPECIALISTS
Thrive Retirement Specialists is a retirement planning specialist dedicated to delivering a more thoughtful and strategic approach to retirement planning for those nearing or in retirement. We are a fee-only Registered Investment Advisor (RIA) offering a single, flat-fee service entitled ThriveRetireTM that goes far beyond what has traditionally been known as retirement planning. ThriveRetire™ is an engaging ongoing 8-step retirement planning process and investment management service that seeks to identify all risks, assets, tools, and tactics to develop an optimal retirement plan designed to support your ideal retirement lifestyle and goals to the fullest extent possible. With every interaction, we seek to inform and serve, so our clients can safely trust their ThriveRetire™ plan and process, leaving each client with the confidence and peace of mind to live a vibrant and full life through retirement.
ABOUT ANTHONY WATSON, CFA, CFP®
Prior to founding Thrive Retirement Specialists, Tony spent eight years serving as the Chief Investment Officer of a firm where he provided advice and investment management services to over 600 individuals representing at the time over $1.5 billion of investments. Before this, Tony served as Vice President at J.P. Morgan Private Bank, where he advised high- and ultra-high net worth individuals on all matters of wealth, including investments, portfolio construction, portfolio management, and retirement planning.
Tony lives in Dearborn, Michigan, with his wife Dawn and daughters Emma and Anna.
- BBA in Finance, Walsh College
- MBA, University of Michigan, Ross School of Business
- Chartered Financial Analyst (CFA)
- Certified Financial Planner (CFP®)