As the end of the year approaches, most people start to get a clear sense of how much income they will have for the year. If this year looks like a relatively low year for income, it may be worth exploring intentionally increasing your “total income”. While the reasons may differ from year to year, Roth Conversions during low-income years may be a great way to reduce your lifetime tax bill for your retirement accounts.
Key Takeaways
- Traditional retirement accounts give you an upfront tax deduction, but you pay tax on your future withdrawals, while Roth accounts take after-tax contributions, allowing tax-free withdrawals. The “best” option between these two accounts depends on when you expect to pay lower taxes.
- Use Roth conversions strategically to shift money from traditional to Roth accounts during years when you are at a lower tax rate, allowing you to pay taxes when they’re cheapest.
- To determine if a Roth conversion is worthwhile, estimate your annual taxable income and work with a tax professional to model your effective tax rate with and without the conversion, then convert up to the point where your tax bracket advantage ends.
Traditional vs. Roth
Most people have some experience with Traditional retirement accounts. This is generally through the basic 401k, 403b, IRA, or other similar account. The purpose of these accounts is to help you save for retirement and get a tax break for doing so. Every dollar you put into one of these accounts, you can receive a tax deduction for the year. Especially for those trying to max these accounts by adding $20,000 to $30,000 each year, the deductions can help save quite a bit on taxes.
It seems that lately, the opposite concept, the Roth account, is becoming more mainstream. So much so that in the latest tax bill, Congress now requires that catch-up contributions to retirement accounts for some people must go into a Roth account. Roth-style accounts do not offer a tax deduction for contributions. Therefore, the money you place into a Roth 401k, Roth IRA, or similar account is considered after-tax dollars.
From a tax planning perspective, the difference between which account is “better” depends on when you spend the retirement contributions. While the Traditional account may provide a deduction now, the drawback is that when you withdraw money from the account, it will likely be subject to taxes. Compare that to the Roth account, where, since you paid taxes before contributing to the account, you will never owe taxes again and won’t pay taxes when you withdraw money.
Roth Conversions
Instead of thinking about Traditional and Roth accounts as an either-or decision, it can be more helpful to think about it as a conversion process. For all retirement money you save, it will get taxed at some point (whether at the beginning or the end). Therefore, the general strategy is to pay the taxes when the tax rate is relatively lower. For example, if you are in a 30% tax rate today but will likely be in a 10% tax rate in retirement, then you would want to wait to pay the taxes in retirement. So, in this scenario, a traditional contribution is superior to the Roth contribution.
Most people have a disproportionate amount of retirement money in traditional accounts, and as a result, less in Roth accounts. Roth conversions can help start the “conversion process” to eventually move all the traditional retirement money to Roth. Since we can control how quickly this process occurs, it may be beneficial to do more Roth conversions in years when the total income is lower and therefore creates a lower tax rate. Imagine a business owner with a 40% tax rate who plans to die running his business. If this year, revenue is down and his tax rate drops to 25%, it could be a perfect year for a Roth conversion to capture the lower tax rate.
Another common situation for Roth conversions is for young retirees. For those who may retire before social security or a pension starts, they could have multiple years of a relatively low tax rate before that new income kicks in (and bumps them back up into a higher tax rate). Some retirees do not even file taxes because they do “not have enough” income. While that is great in one aspect, if they are sitting on 6-figures of traditional retirement money, they could be missing out on a 0% tax rate for most of their yet-to-be-taxed money.
The Tactics
For those who suspect a Roth Conversion could be worth it, the first step is to figure out how much taxable income you have for the year. Sometimes this can be simple, such as a young retiree who only lives on IRA distributions. Other times, it may be an educated guess, such as a business owner who can clearly see that sales are down this year, but December could still be up in the air. The closer someone can get to the actual income that will be reported on the tax return, the easier the Roth Conversion calculation.
The next step is to contact your accountant or tax advisor. After receiving all the income sources, the CPA can calculate what your effective tax rate likely will be. More importantly, they can also calculate an effective tax rate if you also did a Roth conversion. A simple example that we are commonly seeing right now is couples in the 12% federal tax bracket. Since we have built out their retirement plan, we are confident that they will likely be in the 12% bracket (or higher) indefinitely. As a result, we then generally recommend a Roth Conversion for as much money as possible until they reach the 22% tax bracket.
A word of warning though, some calculations may not be as simple as others, so it is important to work with a professional first. Many times, there are extra variables that need to be considered, whether that is the QBI deduction, Social Security tax, Net Investment Income tax, IRMAA brackets, charitable deductions, capital gains tax, and others. Once everything is factored in and a Roth conversion amount is dialed in, the actual process can be fairly simple. A form or two should generally be sufficient for your advisor to convert the funds from your IRA to your Roth. For 401k money, it may take slightly longer if that process must go through the employer, or if you have to roll out the money first.
Year-End Planning
Roth conversion and other similar tax planning strategies are relatively easy ways to reduce your lifetime tax bill. Especially for retirement accounts, the IRS will eventually tax those hard-earned savings. The more you can control when those taxes occur, the more likely those taxes could be at a lower tax rate. Roth conversions are generally a long-term, multiple-year strategy. Eventually, the goal would be to have after-tax retirement money that you can do what you want with, without the government’s input.
TC Falkner 