Roth Conversion Abracadabra!
TLDR; Roth conversion can be a great tax planning strategy that takes advantage of the changing tax brackets throughout your lifetime. By converting funds during your low-income years, you can potentially save a significant amount of money in taxes and reduce your RMD amount. However, evaluating all possible consequences is crucial before making any decisions.
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I did a happy dance last week because I put together a plan to save a lot of money for a client by using strategic Roth conversions in her low-income years before she needs to take RMDs (Required Minimum Distributions). I know I might have lost you by now with the jargon already, so let's take a step back to understand some key concepts first:
Roth Conversion
A Roth conversion moves funds from a traditional IRA or 401(k) account into a Roth IRA. This can be done in various ways, including through a direct transfer or a rollover. The primary benefit of a Roth conversion is that it allows you to convert taxable retirement savings into tax-free savings by paying tax now instead of later.
Required Minimum Distribution (RMD)
RMD is the amount of money that MUST be withdrawn from certain retirement accounts starting in the year that the account owner turns RMD age (currently 72, but will be later depending on the year that you’re born after SECURE ACT 2.0 was passed).
The Benefits
Now that we clearly understand these concepts, let's delve into why Roth conversion can be an excellent tax planning strategy. The primary advantage of this strategy is that it takes advantage of changing tax brackets throughout your lifetime. While most of us believe that our tax bracket remains constant, it, in fact, varies over time.
Roth conversion could:
Lower our tax bill when we pay taxes in our lower tax years AND/OR
lower our tax bill even more by decreasing our RMD amount.
Tada! Pretty amazing, isn’t it?
Scenarios for Roth Conversion
There are several scenarios where Roth conversions will be helpful:
You expect a high RMD in the future, primarily if your primary asset is in your pretax IRA, 401(k), or other retirement accounts. You have a low-income year, such as when you retire, have a gap year from switching jobs, or experience a lean year if you're self-employed.
You want to leave a tax-free inheritance. By converting some of your traditional IRA or 401(k) funds to a Roth IRA, you can leave a tax-free inheritance to your heirs, as Roth IRAs are not subject to RMDs during the original owner's lifetime.
If you know me, you can probably hear me yell, "As good as it sounds, this is not a one-size-fits-all situation!" Before making any decisions, consider the tax implications of Roth conversion carefully. It may only be worth it if you have the cash flow to pay the taxes now. Additionally, converting too much could push you into a higher tax bracket, affecting other entitlements and tax credits. It's essential to understand all the ripple effects before making any decisions.
Cheers!
Lei Deng, CFA, CFP®
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