Is a Roth Conversion Right For You?

Smart investors know how to minimize their lifetime tax bills. If you’re curious how you can create tax-free income in retirement, stay tuned.

Minimize your lifetime tax bill: Is a Roth conversion right for you?

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Full transcript:


Anthony Saffer & Alex Okugawa

Alex Okugawa 0:08
So before we get into what a Roth conversion is, it’s important for everyone to know that a Roth conversion is permanent. So before you go making any of these big decisions, you want to consult with your tax advisor and financial advisor as well.

Anthony Saffer 0:25
Yeah, it can be a bit complicated. So what we’re talking about here is to create tax-free income in retirement, a Roth conversion can be a great strategy for that, right. So generally, with a traditional IRA, or a lot of times people accumulate money in their 401k, or retirement plan, they’re putting money in pre-tax, getting a tax deduction on that. But when it comes out in retirement, they’re paying taxes on that full amount. So by converting it over to the Roth, that’s where you’re creating a tax-free income stream.

Alex Okugawa 0:52
Now, when when you got to make your conversion, in the year that you take some of your traditional IRA money and you convert it to a Roth, the year you do that you pay taxes. And so a lot of people are wondering like, Well, why would I do that? Why would I create a big or potentially taxable event? In the current year when I don’t have to worry about that way down the road? If I just let it be?

Anthony Saffer 1:14
People think that we’re in a low tax rate environment, right. That’s, that’s pretty commonly agreed upon right now because we are historical. So if we’re thinking that tax rates are going to go up in the future, I’ll get tax now, at a low rate. That way, I save taxes later when I get into retirement.

Alex Okugawa 1:31
And of course, the other thing too, is, like we’ve mentioned, qualified withdrawals from a Roth IRA are tax-free. And the thing is, is a lot of retirees I think, underestimate what their taxable income is going to look like in retirement, when you consider things like social security, right, up to 85% of your Social Security benefits can be taxable, maybe have some rental income, some other income on the side here, and they’re coming in. And then you add on top of the fact that with an IRA account, you will be subject to what are called required minimum distributions under current law when you turn 72. And that’ll start forcing money out to you. So all of a sudden, your taxable income is starting to add up. And I think that catches retirees by surprise going, Oh, my gosh, I didn’t expect to have all this income, which is a good thing. But now I got to pay a lot in taxes,

Anthony Saffer 2:17
And people are often surprised, they say, Okay, well, I need, you know, this amount of money from my IRA every month, $4,000, whatever it is, but to pay the taxes on that, I got to take out, you know, 5000, to 6000. To net me, 4000, it’s quite a bit.

Alex Okugawa 2:31
One other thing I’ll just mention about Roth conversions is it does not have to be an all-or-nothing decision, right? Meaning that you don’t have to convert your entire Ira balance, you know, if you have, let’s say, like a $500,000, Ira, maybe you do $10,000 In one year, and maybe 20,000 In the next, just depending upon what your tax bracket looks like. But you can do these small partial Roth conversions that fill up your lower tax brackets. And that’s really where the tax planning comes into it.

Anthony Saffer 3:01
Yeah. And the incremental strategy does work, well, we find it to be that but even then it’s a year by year decision, you might have a year where you have low income, you have more deductions from charitable giving, whatever it may be, then at that point, you say, Okay, I’m going to do more of a Roth conversion this year. And then maybe on the opposite, you have a high-income year with fewer deductions, so you don’t do any.

Alex Okugawa 3:22
Absolutely. So let’s talk about, you know, who does this apply to, like, who are good candidates for a Roth conversion?

Anthony Saffer 3:28
Yeah, so like we just mentioned, if you’re in a position where you’re in a low tax bracket, whether that’s like permanent, and you feel like you’re going to be in a higher tax bracket in retirement, or you just have that one specific year or years where you have lower income or deductions that can make it can make sense, okay.

Alex Okugawa 3:43
Now, what about folks are to your point to one of the things I see this a lot is, let’s say you make a lot of charitable donations that are given here, like if you do a lot of charitable giving, maybe you know, more advanced settings like you give the property to a charitable remainder trust or do something like that, that could present a good opportunity to Roth conversions. But let’s talk about those are the good candidates, let’s talk about people that might not be good candidates, those are bad candidates where the Roth conversion might not make sense for them that here.

Anthony Saffer 4:10
If you’re in a high-income tax bracket, and that’s, that’s where there’s no black and white answer, everyone has to make that decision for themselves. But if you’re in a relatively high tax bracket, then it might just not be the thing for you. And maybe what you want to do is just make some of your retirement plan contributions directly to a Roth, rather than try and do a conversion where it’s not necessary.

Alex Okugawa 4:29
Yeah, one other person that I think this might not apply to or not, might not be the best strategy for is people who don’t have enough cash on hand to pay the tax bill upon conversion, right. That’s a really big piece in this because like we mentioned earlier when you do make your conversion, although it could be good for you long term, you are going to have to pay taxes in the year that you make the conversion. So if you don’t have the cash on hand to pay that tax bill, it doesn’t make the math just usually does not make sense to then pull more money out of your IRA. To then cover that extra tax bill.

Anthony Saffer 5:01
Yeah, that’s a good point. The math doesn’t work out in that situation. Here’s where I recommend it. And I think when people can get money into a Roth, independent of the amount, if you can get some into a Roth somehow, some way, it creates more tax flexibility when you get into retirement, because like you started out mentioning, you know, you have Social Security, that’s taxable. Maybe you have other, you know, pre-tax income, that that’s coming out, yep, from IRAs, having some can help you navigate the tax brackets to say, well, I’m going to take more out this particular year, more than I’m used to, I’m going to take that from my Roth. So I don’t, you know, slip into the next tax bracket.

Alex Okugawa 5:38
Now, Roth Conversions can be an area where it involves like we’re talking about, a lot of different areas involves, you know, your tax brackets. Now, what am I doing in the future? What is your income look like? What is your tax rate look like right now? So there’s a lot of different moving pieces. And I think what happens is a lot of people go, you know, this is a lot off, think of it as kind of like hiring a financial adviser. Oh, yeah, I know, I need to do that. But I’ll do it down the road. The problem is that we don’t know if these strategies will be here forever. I mean, right now we’re proposing or the tax proposal on the table is set to eliminate base like Roth conversions for high-income folks. I think it’s after 2032. So who knows how long all these different strategies or strategies are going to be available? I think the main takeaway is you need to take advantage of these strategies when they are available to you because we don’t know how long they’ll be around.

Anthony Saffer 6:26
Yeah, and I’ll take the opposite into that to where people oversimplify it. Yeah. And they go, Oh, I’m in the 22% tax bracket. So that’s what I’m going to pay. But what they don’t count on is okay. Does the Roth conversion is going to push me into a higher tax bracket? am I considering state tax? am I considering how it may affect Medicare premiums if I’m in retirement already, these types of things where it affects the rest of the tax return?

Alex Okugawa 6:48
Absolutely. Now, this strategy, as I mentioned earlier, typically works best over a multi-year plan, really take a look at the financial plan your tax brackets, what things look like in the future, to help you minimize your lifetime tax bill and hopefully create some tax-free income in retirement. This is the kind of stuff that we help folks with. If you’re interested, you can visit our website or give us a call to learn more. We’d love to talk with you

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