Now that we have entered October, the year-end tax planning cycle is starting to pick up. For many that hopefully means attempting to determine their total income for the year and look to maximize their income from a tax perspective. That is when IRA to Roth Conversions enter into the conversation. For those with money in traditional retirement accounts like an IRA or 401k, a relatively low-income year could be an excellent planning opportunity to reduce your lifetime tax bill.
What is a Roth Conversion?
At any point in the year, the IRS allows someone to convert money from a pre-tax account like a traditional IRA to a post-tax account like a Roth IRA. You may likely have a traditional IRA from rolling over an old 401k at a previous employer. Many people will save for years in their retirement account at work, and after changing jobs they want to take their retirement account with them. After years of work and contributions, some people will naturally generate a relatively large pre-tax IRA.
From a tax perspective, this is a major problem that must be solved. You claimed a deduction for each pre-tax contribution that went into your retirement account. While that felt nice at the time, the IRS expects you to pay taxes on that money eventually. At least for traditional IRAs and 401ks, the government provides a deduction for contributions but not for distributions. As a result, distributions from your traditional IRA are considered taxable income.
The top federal income tax rate is currently 37% and the lowest is obviously 0%. At least on the federal level, your IRA distributions will theoretically be taxed somewhere between 0% and 37%. If you have $1,000,000 in an IRA, that can be the difference between $0 and $370,000 in taxes. This is why tax planning is so important.
You may ask: Why do I ever need to distribute the account? Can’t I take the amount I need each year and leave the rest until I die? You can, but the IRS still wants the taxes. Once you get into your 70s, the IRS requires you to distribute part of your account each year. The ‘never-touch-it’ strategy could backfire if the IRS Required Minimum Distribution rules eventually force you into a higher tax rate.
God willing, time is the best tool you have to get closer to a 0% tax rate. While most people will not fully get to a 0% tax rate, spreading out your distributions over the years can significantly reduce the amount of taxes you owe. The goal is to take more distributions in years with a low tax rate and stop distributions in years with a high tax rate. So, the question of which years to distribute the funds is when the Roth Conversion enters the picture.
Who Can Benefit from a Roth Conversion?
The good news is that Roth Conversions could apply to anyone with traditional IRA money (or even SEP IRAs, Simple IRAs, 401ks). Fundamentally, if there is a year where the current tax rate is lower than the expected tax rate in the future, you should consider converting IRA money to a Roth IRA. Having a healthy balance in both pre-tax accounts and post-tax accounts can help you better control your taxes when it is time to spend your money.
For example, a lot of business owners and professionals choose to retire early, or at least earlier than when the government or their employer thinks they should retire. In many of these cases, people will supplement their lifestyle with distributions from their retirement accounts before other sources of income kick in (like social security, pensions, etc.). If you did not contribute to any post-tax accounts or do any Roth Conversions, you again could be forced to pay a higher tax rate.
A Roth conversion is one tool in the broader income and tax planning conversation, but it is usually more effective years before the money actually needs to be spent. It may be wise for larger Roth Conversions many years before retirement, just to take advantage of lower tax rates when income is relatively lower.
Here’s another example, we just started working with a business owner in his mid-30s this year. His CPA told me he recorded a loss on his tax return for 2023 (in other words, no taxable income). In our income planning projections, we are planning for his one-man shop to return back to high 5 figures to 6 figures in profit for the next few decades. While there are other factors to consider as well, last year would have been a perfect opportunity for a Roth Conversion since his federal tax rate was 0%.
The Process
There are three main steps to successfully convert IRA money to a Roth. First, update your financial plan and estimate your total income for the year. We generally wait until the last few months of the year for Roth Conversions specifically for this reason. When we can realistically estimate what the total income will be for the year, we can back into how much of a conversion we should add on top. Then the conversion, from a tax perspective, is similar to receiving an extra paycheck from your company at the end of the year that you immediately put into your Roth IRA.
Second, confirm with your accountant that the strategy will work. Accountants can help compile all the income information for the year and estimate how much tax will be owed. If you do not hear from your accountant except for one week in April, it will be much more difficult to maximize this strategy. Many times, a financial advisor can provide recommendations on how much to convert, but your accountant (or your tax software) must understand how the extra income could affect any other potential tax areas. Our goal would be to have the accountant finish those projections, and then verify the additional income from the conversion would have the expected amount of additional tax.
Third, after confirmation, the physical process should usually take a few days and some paperwork from your financial institution. At Legacy, all we need is to open a Roth IRA and sign a Roth Conversion form and it can be completed within a few business days. It is important to note that these conversions must be completed by year-end, not by the following April.
Roth Conversion Considerations
Roth conversions are not right for everyone, and many times it could not be wise to convert IRA money to a Roth. When it comes to reducing your lifetime tax bill, the game of tax rates will always be a consideration in your financial life. It is important to understand how the variables factor into tax planning decisions. If you find this year is a relatively lower income year, then ask your financial professionals if a Roth Conversion is right for you.
TC Falkner 