Roth conversions are like a prepaid vacation—it costs you upfront, but you get to enjoy the experience without a bill hanging over your head. More technically, a Roth conversion refers to the practice of transferring money from a traditional IRA into a Roth IRA. This transfer triggers a current year tax bill, but in exchange you receive tax-free withdrawals and reduced required minimum distributions (RMDs) throughout retirement.
By paying some taxes now, you may pay less later for two reasons. The first is straight forward—you can access tax-free withdrawals from Roth IRAs. But the second, and arguably more powerful way, is a reduction in RMDs, which are mandatory retirement account withdrawals after you reach a certain age. Roth IRA balances are not considered in RMD calculations, so the mandatory amount would be lower.
But much like a Disney cruise, Roth conversions are not for everyone. There is a financial principal known as time value of money, and in its most basic form, it means that money in your pocket now is worth more than money in your pocket later. As a result, there is a considerable hurdle to overcome in justifying a Roth conversion and triggering a current tax bill.
How do you know if the benefits are worth the cost? There is no guarantee, but there are situations that make it a reasonable assumption. For example, many retirees will have an income dip between their last working year and the first year of their RMDs (SECURE Act changed from age 70.5 to 72), and that dip can allow you to “fill in” lower tax brackets with Roth conversions.
The biggest jump is between the 24% and 32% tax bracket, which for married filing joint taxpayers in 2021 happens at $329,851 of taxable income. So if you fill in that 24% bracket with Roth conversions during the pre-RMD, lower income years, you could stay out of the 32% bracket once RMDs kick in and save 8% per year in taxes on income that would have otherwise fallen into that 32% bracket.
Roth conversions are not a cure-all for tax planning during retirement, but they are certainly a useful tool to have in your financial toolbox. Especially now, political tides have shifted and the prospect of tax increases for those with over $400k of taxable income has increased. So keep this strategy in mind and discuss it with your financial advisor to see if it may be right for you.
Josh Norris is an Investment Advisory Representative of LeFleur Financial. Josh can be reached at josh@LeFleurFinancial.com.
