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In Some Cases, Roth Conversions May Make a Lot of Cents…

I know…I know. But, even I have to admit the subject of Roth conversions is dry so we have to create humor when we can. As I was saying…in some cases, Roth conversions may make sense but not always. It can be a complex decision dependent on many factors. Let’s cover a few.

Last week I wrote about some considerations for pre-tax vs Roth contributions to a retirement account. Regardless of whether you are currently making Roth or pre-tax contributions to your retirement accounts (401k, Thrift Savings Plan(TSP), or IRAs), there’s a good chance you have at least some pre-tax money in your retirement accounts. That’s not necessarily a bad thing but it does mean that on a regular basis (perhaps as often as every year) you should consider whether it makes sense to pay tax on the money now (by executing a Roth Conversion) rather than waiting until later.

As discussed last week, the goal is to pay tax on your retirement money when you believe your tax bracket will be lower. Simply speaking - are you in a lower tax bracket this year than you expect to be in when you’re in your retirement years?

While you’re working, it may not make sense to create even more taxable income with Roth conversions. However, there may be a case in which your taxable income will be lower for a year or period of years. Perhaps you will take a year or so off between your military career and your new civilian career. Or, you’re a FERS planning to retire around age 57. Although you’ll have a pension and the Social Security Supplement, your income is likely to be less than during your working years, and, quite possibly, also less than when Required Minimum Distributions begin in your 70s.

Let’s assume you’re preparing for such a situation and are considering how Roth conversions might fit into your situation. What factors should you consider?

Convert from where?

First, you’ll need to identify which pre-tax retirement account may have money that is eligible for a Roth conversion. If you have a Traditional IRA, you can certainly convert some/ all of the money to a Roth IRA. But, the rules are more complicated for 401ks/ TSP. In general, you cannot convert money from your current employer’s 401k/ TSP to a Roth IRA unless you are over a certain age, in most cases - age 59 ½. However, if you left an employer and still have money in your old 401k/ TSP, you likely can convert some/ all of the pre-tax money.

How much?

Next, you’ll need to determine how much you should convert in the current year. This is a complex decision and it definitely will impact your tax situation for the year. Before you do anything, it is critically important to understand the impact to your specific situation. You should speak with a tax professional who is able to prepare an annual tax projection for you. And, it’s not just so you can be prepared for the higher tax bill.

Keep in mind that your annual taxes can influence a variety of other situations including your eligibility for certain deductions, credits, or other programs. For example, if you have a child within a couple of years of college, a Roth conversion will impact your Free Application for Federal Student Aid (FAFSA).

You may already be thinking - this is just too hard to deal with right now. I don’t blame you. It’s a complex decision. You definitely should consult a tax advisor. You definitely will have to do paperwork. You definitely are going to pay more in taxes (than you otherwise would for the year of the conversion).

WHY would you do this to yourself?

There is a common quote around these days “Choose your hard”. The fact is that you are going to do this work at some point. You’re going to pay taxes on this money today or you’re going to do it in your retirement years. You’re going to look for advice today or you’re going to look for it in your retirement years. You’re going to do paperwork today or you’re going to do it during your retirement years.

The question to consider is whether you are better off, over the long term, to handle the “hard” today or put it off. The paperwork is a pain and maybe finding the right advisor is a pain but the biggest pain for most people is the tax bill. The question is whether you want to pay the tax on your terms (in a year of your choosing) or in a year of the government’s choosing.

Dusting off the Case Study

Remember Celia from last week? It’s ok if you don’t. I don’t even remember what I had for dinner last night so let’s quickly review. Celia is a (fictional) GS13 Step 10 FERS employee in the DC locality pay area. She’s been with the government since she graduated from college at age 22. She’s 55 years old and plans to retire at age 57. She has only ever contributed 5% to the Thrift Savings Plan; she has no other outside investment accounts. Her current TSP is invested in roughly 60% equity and 40% fixed income. She is comfortable leaving her portfolio this way throughout retirement. Let’s assume she will file for Social Security at age 67. For simplicity, Celia isn’t married and doesn’t have children.

Let’s assume that Celia has spoken with a knowledgeable financial planner and they are analyzing her entire financial situation to determine if/ when Roth conversions may support Celia’s longer term financial goals.

Let’s also assume that Celia is willing to “fill up” the 22% tax bracket (which will become the 25% tax bracket when the 2017 Tax Cut and Jobs Act tax brackets sunset at the end of 2025). This means that any year in which Celia’s earned income, pension, and/ or Social Security income is less than the top of the 22% tax bracket, Celia is going to convert some amount of “pre-tax” money to a Roth IRA. She will pay the taxes for the conversion out of her existing cash/ cash flow.

The profile of the chart on the right is Celia’s Federal tax bill for each year from age 55 to age 95 without completing any Roth conversions. As you can see, her tax bill increases substantially when her RMDs begin at age 75. Although her tax bill is relatively lower until age 75, she still is projected to pay about $1.5M in Federal taxes over her remaining lifetime.

Now look at the chart on the left. This chart assumes that Celia completes some Roth conversions every year between age 55 and 75. She converts enough to “fill” up the 22%/25% tax bracket each year. You can see that she would need to accept higher tax bills in her younger years. But you can also see that by doing so she pays about $500k LESS in Federal taxes over her remaining lifetime.

And now you can appreciate my earlier pun. For Celia, Roth conversions do, literally, make a lot of cents!

Some (more) Key Points

One point I’d like to make, since it’s not clear in the charts, is that Celia is sacrificing current income to pay her Roth conversion tax bills. She is NOT using her retirement accounts to pay the tax bill for the Roth conversions. There could be a substantial difference in her overall retirement outcome if she were to instead pay taxes from her retirement accounts. You may find that you are not able to enjoy your lifestyle while paying more taxes out of your current income or taxable savings/ investment accounts. It’s a factor to consider in your Roth conversion decision.

As noted last week, we created Celia’s situation to be very simple specifically to highlight the potential magnitude of Roth decisions. Your situation is much more complex and therefore you cannot assume the same orders of magnitude if you complete Roth conversions. There are many additional factors you should consider, not to mention a variety of assumptions and scenarios that could be in play for you and your family.

Having said that, if you are within a few years of a transition, it could be worth your while to speak with a knowledgeable financial planner to discuss what Roth conversion might look like for your specific situation.

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