ROTH Conversions: Pros, Cons, & Variables To Be Aware Of
Through my experience working alongside clients, I have received many questions concerning the potential role and implications of utilizing ROTH conversions.
So, today we will be reviewing what a ROTH conversion is, how it is taxed, when is typically good time to consider this strategy, and what you need to be aware of.
What is a ROTH Conversion & why would I consider this?
As a general statement, a ROTH conversion involves the process of withdrawing money from your pre-tax retirement account, paying the appropriate tax, and depositing the funds into an Individual ROTH IRA. From there, the funds invested in the ROTH will grow tax-deferred and the entire conversion amount can be withdrawn tax-free as long as 5 years have gone by.
Furthermore, one can always withdraw the conversion amount prior to the 5 years (without penalty or tax) as this amount has already been taxed - the earnings will be tax-free once the 5 years have passed. One thing to be aware of here is that each ROTH conversion has its own 5-year clock – so if you convert $50k in year 1 and $50k in year 2, they each have separate 5-year clocks.
Some may ask…. why would you consider a ROTH conversion? Typically, it is an opportunity to move pre-tax monies to post-tax monies in anticipation of being in a higher tax bracket down the road. Moreover, if this strategy is started early enough, this could be a way for a client to reduce their projected Required Minimum Distribution (RMD) amount and also pull this money out at a lower tax bracket compared to the projected bracket at their RMD age.
As a reminder, an RMD is the required minimum amount the IRS requires you to withdraw at a specific age. Considering recent changes from Secure Act 2.0, if you were born between 1951-1959 your RMD age is 73, if you are born after 1959 your RMD age is 75.
How is the conversion taxed & when is a good time to consider this?
When you convert these funds from your pre-tax account, you are paying ordinary income taxes (based on the marginal brackets in a specific year) on the amount converted, plus income taxes on any other income you are receiving during the calendar year – pension income, Social Security benefits, interest, dividends, earned income, etc.
Typically, I have clients consider this strategy when we anticipate experiencing a lower income year(s), if they have just retired and have enough cash or taxable investments to fund their lifestyle while we facilitate a few years worth of ROTH conversions, or prior to turning on Social Security benefits. If an individual does consider doing a ROTH conversion while still working, they need to keep in mind that the amount they convert will be tacked onto their overall income – which could bump them up to a higher marginal tax bracket, and in turn, have them pay more taxes than if they waited until their income decreased.
In my opinion, the key here is to maximize tax efficiency by understanding what marginal tax bracket you are in today and using some assumptions to estimate your bracket down the line to determine the proper timing. Simply put, you are designing a strategy to reduce your lifetime taxes, rather than in one specific year.
Moreover, a best practice I suggest is that clients should have the money set aside in cash to pay the tax on the conversion – by doing so the entire conversion amount gets deposited into the ROTH IRA. For example, if a client wants to convert $100,000, we would convert $100,000 from pre-tax to ROTH and pay the tax out of cash so the full $100,000 is converted. Rather than only truly converting $80,000 out of the $100,000, as $20,000 would go to the IRS as a result of 20% federal tax in this example.
*ATTENTION – if you are under age 59.5, planning to perform a ROTH conversion and have the taxes withheld from the conversion amount, you should be aware that the amount withheld for taxes falls under early-distribution rules, and could be subject to a 10% penalty on the amount withheld. For example, if you convert $100k and have $20k withheld for taxes, not only will convert $80k, but you will pay an extra $2,000 (10% penalty tax) on the amount withheld. Therefore, if you are performing a conversion under 59.5, be sure to not withhold any taxes on the conversion and pay the taxes out of cash!!!
Example & variables to watch out for
Two of the biggest variables to watch out for when contemplating ROTH conversions is when / if to turn on Social Security benefits, and how much more of your Social Security benefit will be taxable as a result of the ROTH conversion.
As a reminder, when your MAGI is above a certain income level ($32,000 for MFJ) your Social Security benefits start to become taxable, and above $44,000 up to 85% of the benefit amounts can be taxable.
So, when we think through these strategies, we need to determine what we are trying to achieve, what is the effect on taxes, and weigh the pros and cons to make an informed decision.
Example
Two Clients – ages 62 & 60 MFJ
Portfolio asset level = $1.5 million (all pre-tax) *$100,000 in cash in addition to this
- At RMD age, the client would be in the 22% tax bracket based on current projections of income, expenses, portfolio growth – also factoring in the RMD amount they would be required to take
Pension Income of $24,000 (collecting now)
If age 62 client turns on S.S. benefit will be $29,114
Expenses = $50,000/year (No mortgage)
Scenario 1
Using the above assumptions, let’s say the client turns on Social Security and decides not to use ROTH conversions, the taxable portion of their Social Security benefit would only be $3,222 and they would not have a taxable liability because their taxable income would fall below $0 (after factoring in the standard deduction) - i.e. 0% tax bracket. Clients can take out money from IRA as needed and start RMD’s at age 75.
Scenario 2
Client turns on Social Security and decides to convert $75,417 from pre-tax to ROTH, this puts taxable income at $94,200, which keeps them in the 12% marginal tax bracket – this is lower than the 22% marginal bracket they were in while working and contributing pre-tax.
Sounds good, right? Well, as we discussed above, the more income you have the more taxable your Social Security becomes, so in this case, the taxable portion of Social Security benefits goes from $3,222 in the above scenario to $24,747 in this case! Quite the difference. Not to say that the conversion should not be performed, but this is certainly something to think about.
Scenario 3
In this scenario, let’s say the client decides to hold off on Social Security in order to fully take advantage of ROTH conversions and IRA distributions. The client still collects the pension income of $24,000, decides to convert $78,950 to ROTH, and take an additional $21,000 from the IRA to fund their lifestyle.
In this case, the taxable income is the same number as scenario #2 - $94,200 which keeps them in the 12% marginal tax bracket, however, they are not creating higher tax implications for their Social Security benefits. So, the client can utilize this strategy until age 67 (depending on overall goals & tax plan), then turn on Social Security at 67, and have less of their benefit taxed at that point
So, this strategy accomplishes a couple of notable things:
- Withdrawing funds at a lower marginal tax bracket than contributed
- Reducing the amount that would need to be taken out at RMD age
- Both of the above have the ability to drastically reduce a client’s lifetime tax bill by potentially 6 or 7 figures (assuming the clients live till age 100)
- Eliminates the risk of a higher level of Social Security benefits being taxable
To wrap up, out of the three above, Scenario #3 makes the most sense from a number’s standpoint, but this does not necessarily mean this is the correct choice for everyone – a lot more goes into an analysis than just the numbers!!
You need to go beyond the numbers to truly find the purpose and meaning driving your lifestyle choices.
Hope this was a helpful review!
For a comprehensive review of your personal situation, always consult with a tax or legal advisor. Neither Cetera Advisor Networks LLC nor any of its representatives may give tax or legal advice.