Taking the Hit

Richard Connor

ONE OF MY GOALS for 2020: develop a plan for doing Roth IRA conversions over the next 10 years. Once the money is out of traditional IRAs and in a Roth, it’ll grow tax-free. Problem is, the conversion means taking a tax hit today.

So why am I interested? There are several reasons: lowering lifetime taxes for my wife and me, creating the flexibility to manage future tax bills and leaving a tax-free inheritance to our children. On top of that, today’s depressed stock prices offer a great opportunity to convert shares at a lower tax cost.

My wife and I are both age 62. Last year’s SECURE Act raised the starting age for required minimum distributions (RMDs) from retirement accounts from 70½ to 72. That gives us 10 years to make Roth conversions before we’ll have the enforced—and potentially large—annual tax bills triggered by RMDs.

The decision to convert isn’t a simple one. At its core, it’s a choice between paying taxes today and paying them later. But there are also other significant issues that come into play. Here are seven factors to consider:

1. Whither taxes? As you decide whether to convert, this is the key issue. Would you pay taxes at a lower rate today, if you opt to convert money to a Roth, or would your tax rate be lower later on, assuming you left your traditional IRA untouched and instead simply took distributions some years down the road?

We can’t, alas, predict the future, but we can look to current tax laws. When the Tax Cuts and Jobs Act was enacted in 2017, it reduced marginal tax rates and widened tax brackets. These changes will sunset after 2025 unless Congress passes new legislation.

Reverting to pre-2018 marginal tax rates in 2026 would most likely move my wife and me from the 24% marginal tax bracket to 28%. In fact, many commentators believe that our ballooning government spending will lead to even higher tax rates. I have no idea what will happen, but I strongly suspect future tax rates won’t be any lower than they are today.

2. Paying Uncle Sam. If you convert, you’ll owe income taxes on the sum involved. Conventional wisdom says you should try to avoid paying that tax bill by dipping into your retirement account, because that’ll mean even more taxable income on top of the taxable income generated by the Roth conversion. Instead, you should—ideally—have other money set aside to cover the conversion tax.

3. Today’s bear market. It may seem counterintuitive, but falling share prices offer the opportunity to do a Roth conversion at a lower tax bill. How so? It helps to think in shares instead of dollars. Say you own 1,000 shares of a stock or fund in a traditional IRA. The shares had recently been at $10 but are now at just $5. If you convert the shares to a Roth, you would still have 1,000 shares, but you’d owe taxes on $5,000 of additional income, rather than $10,000.

An added incentive: Roth IRAs have the potential to enjoy a longer stretch of investment growth. Unlike traditional IRAs, Roth IRAs aren’t subject to RMDs once you reach age 72. Instead, the entire account can be left to grow tax-free.

4. Helping your heirs. Roth IRAs are inherited tax-free by the beneficiaries you name. Your spouse can treat the inherited Roth as his or her own, which means there are no RMDs. Meanwhile, non-spouse beneficiaries typically have to empty the account within 10 years. You might advise your heirs to wait until the 10th year to pull money from your Roth, so they get maximum benefit from the tax-free growth.

5. No re-dos. Prior to 2018, you had the ability to undo a Roth IRA conversion up until Oct. 15 of the year after the conversion was made. This “recharacterization” option was eliminated by 2017’s tax law. The upshot: When you convert, you need to be 100% certain you want to do it—because there’s no going back.

6. No early exits. Roth IRAs are subject to the so-called five-year rule, which means you could face income taxes and possibly tax penalties if you tap your new Roth before the five years are up. In other words, if you aren’t sure you can leave your Roth untouched for five years, a conversion isn’t a good idea—and that’s doubly true if you’re under age 59½.

7. Getting it done. There are three ways to execute a Roth conversion:

  • A rollover, in which you take a distribution from your traditional IRA in the form of a check and deposit that money in a Roth account within 60 days.
  • A trustee-to-trustee transfer, in which you direct the financial institution that holds your traditional IRA to transfer the money to your Roth account at another financial institution.
  • A same-trustee transfer, in which you tell the financial institution that holds your traditional IRA to transfer the money into a Roth account at that same institution.

Our traditional and Roth IRAs are at Vanguard Group, so I used its online system to do a same-trustee transfer. It was very easy: Within a day, the shares had been transferred from my traditional IRA to my Roth.

I’m a semi-retired engineering consultant, so my income fluctuates a lot from year to year. My plan: Look at our total income each quarter to assess our projected tax bill and see if we want to do a small conversion. That way, I can move at least some money into a Roth earlier in the year—and potentially enjoy more tax-free growth—while avoiding an overly large conversion that pushes us into a much higher tax bracket.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. Rick enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. His previous articles include Buyer Take Care, Numbers Game and Should You Sell. Follow Rick on Twitter @RConnor609.

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