Many Americans saving for retirement have access to employer retirement accounts such as a 401(k), 403(b), ESOP, SIMPLE IRA, or SEP IRA accounts. Others have contributed consistently to individual accounts such as a traditional IRA. For many individuals, the assets they’ve accumulated in these retirement accounts represent a substantial portion of their retirement savings and will be a primary source of income in retirement. Managing the tax implications of withdrawals from retirements accounts are an important consideration for most individuals, and Roth conversions are a tool that can be used to minimize the taxes paid on retirement account balances.
Before considering the specifics of Roth conversions, it is important to briefly discuss the different types of retirement accounts. While there are many different retirement accounts, essentially all of them can be placed into one of two tax categories, pre-tax or post-tax. From a tax planning perspective, understanding the difference between pre-tax and post-tax retirement accounts is key.
Pre-Tax Retirement Accounts: The majority of retirement accounts are pre-tax accounts. Unless the retirement account includes “Roth” in the name, the account is likely a pre-tax account. A pre-tax retirement account allows individuals to avoid tax on the income used to make the contributions.
The funds contributed grow tax deferred for as long as they remain in the account, but when the funds are withdrawn, the withdrawals will be taxed as ordinary income.
Post-Tax Retirement Accounts: Some employer retirement plans offer a Roth option within the plan, and for individuals who do not have access to a Roth option in their employer’s retirement plan, many still qualify to make Roth IRA contributions. Roth accounts are post-tax accounts which means there is no tax deduction or taxable exclusion up front for amounts contributed to a Roth account. However, all future growth is tax free and withdrawals are not subject to taxation.
To summarize, pre-tax and post-tax accounts both provide a tax benefit. Pre-tax accounts allow individuals to avoid taxation when the contributions to the account are made, but result in taxation on any withdrawals. Post-tax accounts do the opposite. Post-tax accounts provide no tax benefit on the income used for the contribution, but all growth and future withdrawals are tax free as long as specific requirements are met.
Key Takeaway:
Pre-tax accounts reduce taxes up front, but result in taxes on withdrawals. Post-tax accounts do not reduce taxes up front, but eliminate taxes on withdrawals.
Determining whether to contribute to a retirement account on a pre-tax or a post-tax basis requires consideration of many factors, but the theory is simple. Individuals who expect to be in a lower tax bracket in the future should contribute on a pre-tax basis to defer tax now at higher tax rates and then pay tax on withdrawals in the future when they expect to be in lower tax brackets.
Individuals who expect they will be in higher tax brackets in the future should contribute to post-tax or Roth accounts now so that they can take the money out tax free in the future when they expect their tax brackets to be higher.
A common example would be an individual who is currently working and is in the highest tax brackets. It typically makes sense for them to contribute to pre-tax retirement accounts to reduce their taxable income now and then take that money out of the pre-tax accounts after they retire and are in lower tax brackets. By doing this, they can shift income out of their current high tax brackets and into the lower brackets that they expect to be in during retirement.
What are Roth Conversions?
Since pre-tax accounts will ultimately be taxed upon withdrawal (either by the account owner or their beneficiaries), the primary concern for individuals with large pre-tax accounts should be how to extract their money in the most tax efficient manner. Roth conversions can be one of the most effective tools to accomplish this goal.
A Roth conversion transfers money from a pre-tax retirement account to a post-tax retirement account (i.e. Roth). The conversion is a taxable event meaning that any amounts converted will be treated as taxable income. The benefit is that all future growth and withdrawals from the Roth account will be tax free in the future as long as the typical withdrawal requirements are met.
The Roth withdrawal requirements that must be met for tax free withdrawal are:
- The account owner must be at least age 59 ½.
- The account owner must have owned a Roth account for 5 years. However, a Roth account within an employer plan does not count toward the 5 year requirement for a Roth IRA and vice versa.
- For Roth conversions, each conversion is subject to a separate 5 year clock requiring each converted amount to stay within the Roth account for 5 years before avoiding a penalty upon withdrawal. The 5 year clock can be avoided if the account owner otherwise qualifies for an exception to the early withdrawal penalty such as reaching age 59 ½.
When choosing whether to complete a Roth conversion, there is no requirement to convert an entire account; rather individuals can choose to do partial conversions to maximize their tax savings.
The best approach is to do both long-term and year-end tax planning to determine which tax brackets are expected in future years and whether there is room in an attractive tax bracket in the current year. Determining which tax brackets are attractive depends on the long-term tax plan and whether individuals expect to be in lower or higher tax brackets in the future.
If there is room in an attractive tax bracket in the current year, converting just enough to fill up the attractive tax bracket is typically a good strategy. Individuals who do not fill up attractive tax brackets lose the opportunity once the year has passed. Accordingly, it is important to create a tax plan before year end to identify any available opportunities.
To demonstrate, consider the following graph which depicts a family who has determined that the 12% federal tax bracket represents an attractive tax bracket. Each year they should consider a Roth conversion to use up any remaining room in the 12% bracket.
If their taxable income fluctuates from year to year, the amount of a Roth conversion that will make sense will change; however, since they are allowed to complete partial Roth conversions, they can strategically convert just enough to use up the remaining room in the 12% bracket.
By completing strategic Roth conversions, this family is able to ensure they do not pass up room in attractive tax brackets, and they are able to convert their pre-tax retirement accounts to Roth accounts gradually over time.
Key Takeaway:
The majority of retirement account balances are pre-tax, and partial Roth conversions can help move assets from pre-tax accounts to post-tax accounts tax efficiently.
Considerations For Roth Conversions
Before deciding to complete a Roth conversion, it is important to consider both the benefits and the potential pitfalls. While Roth conversions are a great tool for minimizing tax liability, they can also have unintended consequences if not planned properly. The following are potential benefits and things to consider prior to completing a Roth conversion.
Benefits of Roth Conversions:
Transfers Assets to a Tax-Free Roth Account: The primary benefit of a Roth conversion is that it transfers assets from a pre-tax account where all future distributions will be taxed to a Roth account where all growth and future distributions can be tax free.
Provides Flexibility to Pay Taxes When Taxable Income Is Low: While a Roth conversion is a taxable event, a Roth conversion gives the individual the flexibility to decide which year the taxable event occurs. It also allows for proactive tax planning because individuals can complete a partial Roth conversion to use up remaining room in attractive tax brackets.
Allows For Long-Term Tax-Free Growth: Unlike pre-tax accounts that have required minimum distributions that begin at age 72, Roth IRA accounts have no required minimum distributions (RMDs). This allows the balances within the accounts to grow tax-free for your entire lifetime without any requirement to distribute the assets. Please note that this only applies to Roth IRAs. Roth 401(k) and 403(b) accounts do have RMDs, but this can be easily addressed by rolling a Roth 401(k) or Roth 403(b) account over to a Roth IRA once retired.
Provides for Tax-Free Inheritance: Under current law, most beneficiaries of pre-tax retirement accounts must withdraw the balances they inherit within 10 years. Those distributions are taxable income to them.
It is common for many beneficiaries to be in their primary wage-earning years when they inherit a pre-tax account. For example, if a parent passes away at age 85, it is very common for their child to be around age 55 which typically is the same timeframe they are experiencing their most productive income producing years.
Adding substantial inherited distributions from pre-tax accounts at that time often results in paying very high tax rates since the income from the inherited pre-tax retirement accounts is added on top of the taxable income they already are receiving.
If the beneficiary were to receive a Roth account instead, the distributions would still need to occur within 10 years, but the distributions would not be taxable income.
Locks In Current Tax Rates: With current tax rates near historic lows and with the current government debt and annual deficits, it is likely that future tax rates will increase. While it is impossible to know what tax rates will be in the future, individuals who are currently in very low tax brackets and expect that their tax bracket will increase in the future can use Roth conversions to lock in current tax rates by paying the tax now.
Protects Against Tax Bracket Compression: Most married couples file a joint tax return which allows them to utilize tax brackets that are nearly twice as large as the brackets available to single filers. However, when one spouse passes away, the surviving spouse will have to file as a single filer in future years.
The surviving spouse will likely have similar income as they had as a married couple since most estate plans involve passing the assets to the surviving spouse, but the smaller brackets for single filers significantly increase the likelihood that they will be in a much higher tax bracket. Roth conversions while both spouses are living allow the couple to utilize the larger brackets and pay the tax now to reduce the risk of tax bracket compression when one spouse passes away.
Creates Tax Diversification: No one knows what the future holds from a tax perspective. The government may change tax rates, an individual’s income may change, a spouse may pass away, or any number of other factors may change an individual’s future expected tax situation.
If all assets are in either a pre-tax retirement account or a post-tax retirement account, there is no tax diversification. This means that changes in an individual’s taxable situation will have a more pronounced effect on their financial situation.
For individuals who are unsure of their future tax situation and would like to reduce the potential effects of tax changes, considering partial Roth conversions to create tax diversification can lessen the negative impacts of unfavorable tax changes in the future.
Key Takeaway:
Roth conversions can provide multiple benefits to the account owner as well as their beneficiaries.
Things to Consider Prior to Doing a Roth Conversion:
Roth Conversions are a Taxable Event: One of the biggest pitfalls of a Roth conversion is that they are a taxable event. Accordingly, the individual doing the conversion needs to have cash available to pay the taxes. Ideally the tax would be paid from outside funds like cash in a bank account.
For individuals over 59.5 who do not have available cash to pay the taxes, it still may make sense to do a Roth conversion and pay the taxes using funds from the pre-tax account. In that case, a portion of the total taxable distribution would go to pay taxes, and the rest would be converted to the Roth account.
Roth Conversions Can Impact Medicare Premiums: Medicare Part B and D premiums are adjusted based on income. For 2022, Medicare Part B can be as low as $170.10 per month for married couples with income of $182,000 or less or as high as $578.30 per month for married couples with incomes of $750,000 or higher. The income thresholds are based on a two-year lag; so the 2022 premiums are based on income from 2020.
Since most individuals begin receiving Medicare at age 65, they need to understand how Roth conversions at age 63 or later can impact the amount that they will pay for Medicare. While additional income from a Roth conversion can increase Medicare premiums, the conversion still may make sense. Before proceeding with the conversion, it is important to calculate the impact to Medicare premiums and factor that increase into the additional tax to determine whether a Roth conversion still makes sense.
Roth Conversions Can Impact the Taxability of Social Security: Roth conversions should be coordinated with your Social Security strategy. Often it makes the most sense to focus on converting your pre-tax accounts to Roth prior to claiming Social Security. For individuals who are in the Social Security bump zone (see Maximizing Your Social Security – Part 1 for a detailed example), additional Roth conversion income can result in more of their Social Security being taxable.
For those individuals who have already claimed Social Security, the impacts of any Roth conversion on the taxability of their Social Security income must be considered. Ultimately the proper coordination of Social Security and a Roth conversion strategy can eliminate or significantly reduce your pre-tax account prior to claiming Social Security and reduce the amount of Social Security that is taxable in retirement.
Roth Conversions Should Be Coordinated With Charitable Giving: Roth conversions should be coordinated with your charitable giving strategy. Once an individual reaches age 70 ½, they can give charitably from their traditional IRA accounts and avoid paying any tax on the distribution.
Individuals who would like to take advantage of this strategy in retirement should determine how much to leave in their traditional IRA retirement accounts for future charitable giving so that they do not convert those amounts to Roth and pay taxes on amounts that otherwise can be gifted tax free.
Key Takeaway:
The impacts of a Roth conversion must be carefully considered based on your specific circumstances before determining if it is the right strategy for you.
How Much Tax Can a Roth Conversion Save Me?
For individuals who choose to pursue Roth conversions, it is important to understand the potential benefits that can be realized. To provide context, let’s consider an example. To keep the example simple, we will exclude complicating factors such as investment returns and future changes in tax law that are unnecessary to provide context regarding the potential tax savings from Roth conversions.
Facts: A 60-year-old married couple has recently retired. They expect to be in the 22% federal tax bracket once they begin receiving Social Security benefits and required minimum distributions. Until then, they expect to receive approximately $40,000 in annual income from part-time work and a pension. This $40,000 of income offset by their standard deduction leaves them with approximately $70,000 of room each year in the 12% tax bracket.
Assuming they delay Social Security until age 70, they have 10 years to complete partial Roth conversions of $70,000 annually at a 12% tax rate. By utilizing the remaining room in the 12% tax bracket, they are reducing the taxes on their pre-tax retirement account balances from 22% to 12%. By converting a total of $700,000 over the entire 10 years ($70,000 per year for 10 years), they are reducing their tax rate on the amounts converted by 10 full percentage points which results in tax savings of approximately $70,000.
Comparing a second example, consider if the couple above passed away and left $700,000 of pre-tax retirement assets to their children without converting them. If their children are high income earners and are in the 37% tax bracket, they would pay a federal tax rate of 37% on any distributions. With the children paying taxes at a 37% tax rate, the total expected tax due would be $259,000. That is $175,000 more than the $84,000 of tax the couple would have paid if they had converted all $700,000 at a 12% tax rate early in retirement.
The following graph demonstrates the outcomes of each scenario above.
Accordingly, the appropriate tax planning to strategically use Roth conversions to fill up attractive tax brackets can substantially reduce the amount of taxes you and your family pay over your lifetime.
Key Takeaway:
Roth conversions that are part of a comprehensive financial plan can substantially reduce the amount of taxes you will pay during your lifetime.
Conclusion:
Since the majority of American prepare for retirement by saving in pre-tax retirement accounts, an important tax planning consideration is how to minimize the taxes paid on the eventual distribution from these accounts.
Roth conversions can be an effective tax planning tool to minimize the amount of taxes on pre-tax retirement account balances. Since Roth conversions are taxable events and cannot be undone, it is important to analyze all the implications prior to completing a Roth conversion. However in the right situation, the benefits of Roth conversions can be substantial.
If you are interested in having a Family CFO assist you in determining whether Roth conversions would reduce the amount of taxes your family will pay, we would love to connect to see if what we do is right for you.
