The Roth Advantage Part 3: Roth Conversions[i]
As a dad of twin first grader sons with opposing approaches to eating veggies, I see firsthand how delaying gratification can improve outcomes. J, who is willing to start with his veggies, gets through them much easier than E, who saves them for last. With his veggies eaten, J is usually moving on to the things he likes most while E picks at his favorites slowly in a futile attempt to avoid veggies. They both eat them eventually, but it’s a lot easier for J who just eats them first.
Roth conversions for adults are like eating vegetables first to a 6-year-old, the idea might not be palatable when you first hear it, but it could be beneficial in the long run. Just like E’s attempt to avoid the veggies, trying to avoid paying any taxes is futile and delaying the inevitable is unlikely to improve the taste.
So, with that in mind, let's consider why paying your taxes sooner rather than later could be a better approach to retirement.
Roth accounts are after tax, while traditional retirement accounts are tax deferred.
People above certain income levels are unable to make direct contributions to Roth IRAs but that doesn’t mean they have to miss out on getting funds into an after-tax account, there’s a back door, at least for now.
Since 2010, the IRS has allowed conversions to Roth if you pay taxes on the converted amount.[ii] There has been talk about closing the back door, but it has so far survived legislation, its future however, like all things involving tax law remains uncertain.
All other things being equal you will pay more in taxes now to do a Roth conversion, but with a possibility of paying less overall. Trying to delay your taxes for future years may not be the best option especially when we consider that we have historically low tax brackets right now and that is set to revert at the end of 2025.[iii] When people started funding 401ks in the early 1980s the top marginal tax bracket was 70%[iv] nearly double today’s top bracket of 37%! It made sense to assume that in retirement you would be in lower tax brackets than while working but not many people predicted lower tax brackets across the board. Also not predicted by most was that the stretch provisions would be cut[v], meaning in most cases non-spouse beneficiaries of retirement accounts[vi] now have just 10 years, instead of their lifetimes to deplete an inherited IRA.
In other words, your kids might be forced to eat a lifetime worth of vegetables in a decade, perhaps while they’re already in their highest vegetable consuming years!
So, regardless of your palate and how you feel about vegetables there are some compelling reasons to review your diet before the end of the year.
[i] Roth Conversions are complex must be done properly. There are many factors to consider when deciding if this strategy makes sense for an individual or family. It is very important to keep in mind the overall tax situation as well as things like Social Security and Medicare Part B Premiums that could impact the strategy. This is not a recommendation to make Roth conversions, neither Commonwealth Financial Network® or Creative Wealth Management, LLC provide legal or tax advice, always consult a tax professional.
[ii] Assuming it was all pre-tax. Again, always consult a tax professional and beware of things like the pro rata rule, which can add complexity in calculating the tax liability of the traditional accounts have a mix of pre-tax and after-tax funds.
[v] “For defined contribution plan participants, or IRA owners, who die after December 31, 2019, (with a delayed effective date for certain collectively bargained plans), the SECURE Act requires the entire balance of the participant's account be distributed within ten years. This 10-year rule has an exception for a surviving spouse, a child who has not reached the age of majority, a disabled or chronically ill person or a person not more than ten years younger than the employee or IRA account owner. The new 10-year rule applies regardless of whether the participant dies before, on, or after, the required beginning date. The required beginning date is the date an account owner must take their first RMD.” https://www.irs.gov/retirement-plans/retirement-plan-and-ira-required-minimum-distributions-faqs
[vi] Whose original owner died after December 31, 2019 (Beneficiaries of accounts whose original owner died prior to 2020 are still able to stretch)