Soon we’ll be looking at tax day in the rearview mirror, which is the perfect time to plan for future tax consequences. One strategy that’s especially good for recent retirees is converting part of a traditional IRA to a Roth IRA.
First, a little background. Generally speaking, when you contribute to a traditional IRA, you get a tax break immediately but your money is taxed as ordinary income when you take it out later to live on. A Roth is pretty much the opposite. Though you don’t get a tax break upfront, you also don’t pay taxes (including on any growth) when you withdraw the funds.
The Roth conversion. A Roth conversion is simply taking part or all of your traditional IRA and changing it to a Roth. Since the traditional IRA is usually funded with pretax money, the IRS wants its cut — because you won’t be paying any tax when you withdraw the money from a Roth. So to convert, you’ve got to come up with the cash today. The decision simply comes down to deciding whether to pay the taxes now or later.
The simple math. Forget about those complex calculators or rules that dictate you must keep the account open for 10 years or longer for the conversion to be beneficial. The simple math reveals that if your marginal tax rate today is the same as the marginal tax bracket upon withdrawal, you will have exactly the same amount of dollars after taxes no matter which you picked. Or, to put it another way:
- You are better off converting now if you think your tax bracket will be higher in the future.
- You are better off staying in the traditional IRA if you think your tax bracket will be lower later.
Predicting the future is hard. Okay, I said the math was simple, yet I never said predicting tax rates on your future taxable income would be. Here are some things to consider:
Arguments for converting:
- You expect tax rates to be going way up.
- You expect higher income later.
- You are in a low tax bracket today.
Arguments for staying put:
- You expect to have lower income later.
- You are in a high tax bracket today.
- You think there is a chance of a consumption tax like the Fair Tax Act replacing income tax.
Since we can’t answer these questions with any degree of certainty, it seems like I’m giving you a whole lot of useless advice. Well, things aren’t always as they seem. The fact that we can’t answer these questions is precisely why we want to bet on both sides of this simple math. By diversifying against what Congress eventually decides, we provide ourselves with some protection from this huge uncertainty.
That’s why I recommend having some of your nest egg in both traditional and Roth accounts. Because Roths are newer than the traditional, most people have smaller amounts in Roth IRAs than in traditional IRAs. I often recommend partial conversions over time to provide some tax diversification.
This is especially ideal for recent retirees who are delaying Social Security benefits. That’s because marginal tax brackets at that point are typically lower and are likely to go up in the future when Social Security and private pensions (if you have one) kick in.
In addition, starting at age 70½, you generally must begin taking money out of your traditional IRA and 401(k) in what’s known as a required minimum distribution (RMD), and that could put you in a higher tax bracket. A second compelling reason is that some states don’t tax retirement income up to certain amounts. In my home state, Colorado, I can convert $20,000 annually (being over the age of 55) with no state taxes due.
Roth conversions are one of several strategies to pay taxes sooner at lower rates than later at higher rates. Roth conversions, however, can have unintended consequences, such as reducing or eliminating credits or even health care subsidies. The IRS, though, gives us the right to undo part or all of any conversion in what is known as a recharacterization.
Author’s note: While far more complex than I can write about in this post, that recharacterization is the reason I do multiple Roth conversions annually, knowing I’ll likely recharacterize some every year.
Photo: JY Gallery/iStock
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- AARP Foundation Tax-Aide: Get free help preparing and filing your taxes
- Join AARP: savings, resources and news for your well-being
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