Deciding if a Roth conversion is the right thing to do is a challenging decision.
At best, a Roth conversion strategy is an annual puzzle to figure out, hoping for the long-term outcome of reducing lifetime taxes.
At worst, it is speculation and guesswork, effectively a hunch. Where is that crystal ball when we need it?
At my firm, we wrestle with this question a lot. Should we do some amount of Roth conversion and if we think we should, how much?
We do this type of tax planning with the best of intentions. But ultimately, I call this the biggest guess of all.
Will we pay taxes at the time it makes the most sense by doing a Roth conversion now versus later? Will our taxable income be higher or lower in retirement? Will tax rates in general be higher or lower in the future compared to what we know for certain about this year or next year’s rates? These are questions I pose to my clients, and ones that, ultimately, we have to answer to bring clarity on how we will proceed.
As a refresher, a traditional IRA is an individual retirement account to which you contribute pre-tax dollars (and after-tax dollars too – the devil is in the details) and then owe ordinary income tax later when you make withdrawals. A Roth IRA is another type of retirement account where you have paid taxes on the money going in. Then, typically, all future withdrawals are tax-free.
There are a lot of unknowns when it comes to lifetime tax planning. What we do know is that the tax cuts from the Tax Cuts and Jobs Act of 2017 (TCJA) are set to expire at the end of 2025.
Some tax cuts have to do with estate and gift taxation. But other cuts are centered around income and capital gains taxation. Barring any congressional action, a few key cuts could affect many people.
The standard deduction will decrease and generally, brackets will increase.
In 2023-25, a household that might be in the 24% bracket, could end up being in the 28% bracket only because of the sunsetting of the tax cuts. Paying taxes earlier could save 4%.
So, do you convert in a year that you know what the tax rates are, or do you wait for the future when you really have no idea what the situation will be like? Crystal ball, what say you?
Other considerations can influence your decision to do a Roth conversion.
Many people have large, untaxed balances in their traditional IRAs or 401(k)s. As time passes and those balances grow, Uncle Sam eventually comes calling. That is called a required minimum distribution (RMD), currently beginning at age 73 (and ultimately age 75). As balances grow, RMDs grow, which means taxes may also increase. A Roth conversion strategy may help.
When planning for a married couple, when the first spouse dies, the surviving spouse will be filing as single and may be taxed at a higher rate, especially if there are large RMDs.
If you will be giving away a large portion of your wealth to charity, you can deduct donations or give away your RMDs up to $100,000 as a qualified charitable distribution (QCD). In this case, a Roth conversion may not be as necessary for reducing RMDs or future income taxes.
Pros and cons
What I’ve written are my own thoughts as well as ideas that I’ve learned while researching Roth conversion best practices.
Decisions often come down to client preference. Some people just don’t like the idea of paying taxes now, even if they know the rates and what to expect. They take the approach that a dollar not yet taxed is money saved in the present, a “problem” that is pushed into the future.
Other folks want to get it over with, pay taxes now at a rate they already know, and have tax-free, worry-free distributions in the future.
To each their own.
As recently as 1986, the year I graduated from high school, the highest tax bracket was 50%. Go a little further back to 1981, it was 70%. I’ve been around long enough to remember those times, even though I was a kid and didn’t have a clue what taxes were. The year 1963 brought us a top rate of 91%. The highest of all was in 1945 at 94%. We had to pay for a couple of wars somehow.
My takeaway? Rates can go up from where they are now.
Will they? That I don’t know.
I do know that all of this creates a planning opportunity for everyone right now.
So, get planning.
Angie Furubotten-LaRosee is a certified financial planner, professional, speaker, podcaster and founder of Avea Financial Planning LLC, a Richland firm offering fiduciary financial advice and investment management for folks nearing or in retirement.
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