Category: Retirement Planning

When people think about Roth conversions, the conversation often starts with a relatively simple question: Is my tax rate lower today than I expect it to be in the future?

That’s an important question, but it’s not the only one.

I recently attended a Roth planning webinar presented by Jeffrey Levine, CPA/PFS, CFP®, through Kitces.com, and one of my biggest takeaways was just how many factors can influence whether a Roth conversion makes sense.

As a CPA working alongside our financial planning team, this is exactly the type of planning I find valuable. A Roth conversion has tax implications, but its impact can extend well beyond this year’s tax return.

First, what does a Roth conversion actually do?

A Roth conversion moves money from a pre-tax retirement account, such as a Traditional IRA, into a Roth IRA. Generally, the pre-tax amount converted is included in your taxable income for that year.

Why would you voluntarily create a tax bill today?

Because once money is in a Roth IRA, qualified withdrawals can be tax-free, and Roth IRAs aren’t subject to required minimum distributions during the original owner’s lifetime. 

In other words, you may be choosing to pay taxes now in exchange for greater tax flexibility later.

The key word there is choosing.

Your tax bracket doesn’t tell the whole story

A common Roth strategy is to identify years when income is unusually low and convert some pre-tax retirement dollars while you’re in a lower bracket.

That can happen for a number of reasons. Maybe you’ve retired but haven’t started Social Security yet. Perhaps required minimum distributions haven’t begun. Or maybe you had an unusually high-deduction or low-income year.

Those can create planning opportunities.

But simply looking at your federal marginal tax bracket may not be enough.

The webinar illustrated this through what’s sometimes called the Social Security “tax torpedo.” Because additional income can cause more of your Social Security benefit to become taxable, earning an additional dollar can sometimes increase taxable income by more than a dollar.

In the example presented, an additional $1,000 of non-Social Security income resulted in $1,850 of additional taxable income. The additional federal income tax was $407, creating an effective marginal tax rate of 40.7%, despite the taxpayer being in the stated 22% marginal bracket. 

That’s a good example of why Roth planning requires more than simply asking, “What tax bracket am I in?”

There may be a window between retirement and Required Minimum Distributions (RMDs)

One period we pay particular attention to is the window after someone retires but before other sources of taxable retirement income begin.

Imagine retiring at 62. Your wages disappear, but you haven’t started Social Security and aren’t yet required to take distributions from your retirement accounts.

Your taxable income may temporarily be lower than it was during your working years and potentially lower than it will be later in retirement.

Rather than automatically trying to minimize taxes during those years, it may make sense to intentionally recognize some additional income through Roth conversions.

That could mean paying more tax today. But the goal isn’t necessarily to pay the least amount of tax this year.

It’s to consider how the decisions you’re making this year affect taxes over the course of your retirement and even how those assets may be passed down to your loved ones.

Sometimes “filling up the bracket” makes sense

One strategy discussed in the webinar is commonly referred to as filling up the bracket.

Rather than converting an arbitrary amount, you project taxable income and determine whether there is room to convert additional dollars at a tax rate you’re comfortable paying.

But even this requires careful analysis. Deductions, credits, and other income-based thresholds can create effective tax-rate increases within a bracket. 

And taxes aren’t the only consideration.

A conversion increases adjusted gross income, which can have consequences elsewhere in your financial life. That’s why the decision should be modeled before the conversion is made, not after.

Roth conversions don’t have to be all or nothing

Another point I think is important: Roth planning isn’t necessarily a one-time decision.

You don’t have to look at a $1 million IRA and decide whether to convert the entire account.

The webinar discussed strategies that involve projecting taxable income, converting incrementally throughout the year, and adjusting future conversions as the income picture becomes clearer. 

That type of approach can be particularly useful for people whose income isn’t completely predictable.

It also reinforces something we talk about frequently at Note Advisors: tax planning should be an ongoing process, not something that happens once a year when it’s time to file a return.

The tax bill is only one side of the equation

Before making a Roth conversion, you also need to understand how you’ll pay the resulting tax.

The webinar emphasized three steps before converting:
1. Estimate the tax impact
2. Determine whether prepaying the tax makes sense within the overall plan
3. Establish how the additional tax will be paid

That’s an important distinction.

A conversion that looks attractive from a future-tax perspective could become less attractive depending on where the money to pay the tax comes from.

And once a conversion is complete, the planning doesn’t stop. Your investment allocation, asset location, and retirement withdrawal strategy may all need to be reconsidered. 

The bigger question: When do you want to pay the tax?

I think that’s ultimately the more useful way to think about Roth planning.

For many retirees, taxes aren’t something we can eliminate. Instead, we have some ability to decide when income is recognized and, therefore, when taxes are paid.

Sometimes paying more tax today can make sense.

Sometimes deferring the tax is the better choice.

And sometimes a series of smaller Roth conversions over several years can create a better outcome than making one large move.

The answer depends on much more than your current tax bracket. Your income, retirement timeline, Social Security strategy, required distributions, investments, estate considerations, and other parts of your financial plan can all influence the decision.

That’s why we believe tax planning and financial planning work best when they’re happening together.

If you have questions or need help with tax planning, don’t hesitate to reach out by either scheduling a complimentary meeting using the button below or emailing us directly at connect@noteadvisor.com.

No portion of this commentary is to be construed as the provision of personalized investment, tax or legal advice.  Please consult with the appropriate professionals for advice that is specific to your situation.  Note Advisors, LLC can assist in determining a suitable investment approach for a given individual, which may or may not closely resemble the strategies outlined herein.