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Roth Conversions add flexibility and control

Retirement Funding

One for the Money…

If a penny saved is a penny earned, then strategies for managing losses, fees, and taxes should be core undertakings of growing your wealth.

Today, let’s zero in on a strategy for tackling taxes, or at least minimizing the erosion they can have on long-term wealth-building.

When it comes to deciding whether it’s better to contribute to pre-tax account options or Roth, the decision centers on an estimation of which one is likely to produce the greatest after-tax outcomes over time.  It goes something like this: ”If I’m in a low tax bracket now and expect it to be higher later, I should skip the tax break now and contribute to Roth so I’ll owe nothing in the future.”  

In theory, I agree with this assumption, but unless the person is young or has really low income (in which case they likely wouldn’t be investing much or expecting to build significant wealth), the decision is generally not binary.  

What if, instead, a current tax break could be had AND the advantages of Roth could be had in the future as well?

Enter the Roth conversion strategy.  Converting pre-tax monies to Roth is a simple process of recognizing the amount being converted as income in the current year, paying the tax associated with that income, and shifting the funds into the Roth structure.  

There is more than one avenue for doing this, and more than one type of conversion, but for now let’s keep it simple

For many of us, our marginal tax bracket will change over time, starting out low and moving higher as our careers advance, and then generally declining again as we transition from actively working for income to producing income passively through investments and other sources.  Not only are we likely to see changes in our tax situation due to growth in our careers; life events (getting married, starting a family, buying a home, going back to school, or starting a business) have the potential to impact our tax picture and thus our strategy.

By now you can picture a scenario where contributing pre-tax to gain an immediate tax advantage and converting to Roth at a point later can make sense.  The decision could be driven by being temporarily in a lower tax bracket for any number of reasons: having offsetting deductions that make recognizing small amounts of additional income less onerous or just because investment values are low and expected to rebound in the future.  

All create the opportunity to change the tax nature of your investments and pave the way for more tax efficient withdrawals in the future.

Picture this: Let’s say a retired couple needs to withdraw $60,000 per year from their investment accounts and because they made strategic conversions along the way, are fortunate now to have large balances in both pre-tax and Roth IRAs.  Having the flexibility to draw from both gives them more control over their tax liability.  

Assuming they have no other income sources and they take the standard deduction, the first $24,800 of income drawn from pre-tax IRAs will be offset, leaving their taxable income at $0.   Taking the remaining $35,200 from Roth would keep them at zero.  More important than owing no tax is the control they’ve gained by having both tax types from which to create income. And, it shouldn’t be missed that since the first $24,800 in the example was offset by deductions, there was no need to have given up the advantage of making deductible contributions when the money was contributed… Had everything been Roth, this opportunity would have been wasted. 

Strategies like this get even more exciting when capital gain assets are added to the equation, but that’s for another day.

Knowing how much, and when, to convert is part of ongoing planning, not a set it and forget it decision.