Roth Conversions – Is Now the Time?
I always try to find the bright spot in any situation, it’s kind of the type of guy I am. When Covid hit, I remember thinking as terrible as this what is the bright spot here and opportunity to be had. Now, we are facing a market selloff in the first half of the year. Yet again, I find myself asking the question of where are the opportunities given the current situation.
One area I think worth mentioning today is the Roth Conversion. Like anything else, it is very circumstantial, but I figure why not discuss it here for a few moments. This way I can get the thought out of my head and into yours.
What is a Roth Conversion?
A Roth Conversion is when you take a Traditional IRA (pre-tax dollars), and you convert these dollars to a Roth IRA (tax-free dollars). Upon doing so you must pay the full tax during the year you convert, at ordinary income rates, and then these dollars sit growing tax-free for the remainder of their time.
Pros of Roth Conversions
There are plenty of benefits of the Roth conversion. Below are some notes.
- For starters, by doing so these dollars grow tax-free. Thus, any growth in these dollars, post-conversion is completely tax-free.
- There are no RMDs (required minimum distributions) on these funds when you hit 72. Unlike traditional IRA’s or 401(k)’s which require funds to be pulled when reaching the RMD age, Roth IRA’s are immune to this rule.
- Tax rates are still relatively low from a historical point of view. Basically, we don’t expect tax rates to get much lower over time, so considering now is as good a time as any from a tax perspective.
- Tax parity is another great benefit. Essentially, giving you different buckets to pull from in retirement in the hopes of keeping taxes low at that time.
- Inheritance is the last benefit I’ll mention today. Your spouse and heirs will also benefit from tax-free growth upon inheriting these dollars. The amount and time limit differs depending on your relationship with the deceased.
Cons of Roth Conversions
Like anything in life, although plenty of benefits to doing a Roth Conversion, there are also a fair amount of things to be cautious about.
- Not a lot of benefit if you don’t pay the tax due on a conversion from after-tax dollars. Meaning, that although you have the option to pay the tax from the Traditional IRA you are converting, if you do so it taxes away a lot of the benefits of converting in the first place.
- An increase in tax rates is another thing to consider. Although as mentioned above we are in a historically low tax rate environment if still working and you do a Roth Conversion these dollars will increase your taxable income. This may potentially put you at a higher tax rate than you otherwise would be.
- IRMAA, and not your aunt IRMA. IRMAA is the Medicare Income-Related Monthly Adjusted Amount. If you are within two years or sooner of collecting, or are currently on Medicare, any dollars you convert can affect how much your Medicare premiums will be.
Why now? We had this debate in our company weekly planning meeting the other week, which I love as it is a chance for all the planners in our company to talk ideas etc. The concept is simple, assuming you believe in the long-term viability of the markets. Since the markets are down this year, one could convert a greater percentage of their IRA or pay less on what they would have converted prior.
Example 1: You had an IRA of $100,000 to start the year. Today that IRA is worth $85,000. In this example, if you chose to convert the entire IRA today, you would only pay tax on an additional $85,000 of income rather than $100,000 of income. Assuming these dollars rebound you are picking an opportune time to convert.
Example 2: Same IRA value assumptions from example 1. Except in this situation, you only planned to convert $50,000 this year to stay under a certain income threshold. Well, now you would still convert the same $50,000 although only $35,000 would be left in an IRA for the future rather than $50,000.
There is a lot to consider before you take this leap. It is worth meeting with your financial planner to discuss viability for you and how it affects your long-term financial planning. It also likely loops in your CPA and your estate planning attorney depending on the circumstances. Good thing for you, if you are already working with Diversified then we can bring this all to the table under one roof.
Hope you all stay wealthy, healthy, and happy!
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