Roth Conversions: An Alternative to Sitting Tight
We hope you and yours are enjoying the start of summer, whether that means grilling, taking trips, or enjoying the presence (or absence, for our school employees!) of children.
While history shows us that the best thing we can do during a down market is to sit tight and not make major changes to investments, it’s often easier said than done. As we’ve shared over the past several months, in response to this year’s difficult market performance so far, we’ve made tweaks within our models, primarily to tip toward funds that tend to prove more resilient in times like these. This is an action based around investments, but certain planning opportunities have opened up too. The Roth conversion process we’ll describe below isn’t the best fit for everyone, but if you feel like it fits you and are interested, feel free to reach out to us.
What is a Roth conversion?
A Roth IRA is one of the best tax buckets we have. Money you add to your Roth account doesn’t get you a tax break up front like your traditional IRA contributions, but any dividends and gains are never taxed again, even when you take money out, as long as you are 59 ½ or older when you withdraw funds. By contrast, your traditional IRA contributions get a tax break up front but are taxed upon withdrawal. Remember that we try to strategically avoid taxes when your income or tax bracket is high, and strategically pay them when your income or tax bracket is low.
Many people contribute money directly to a Roth IRA, which has a yearly maximum of $6,000 or $7,000 depending on your age. But another way to get money into a Roth IRA is to take funds from your traditional IRA and convert them into the Roth, which can be done in any quantity. When you convert the money, you pay income taxes, both federal and state, in that tax year. Because your income is taxed in your marginal bracket, often it makes sense to convert enough to fill up your current marginal bracket.
Why might a Roth conversion be better in a down market?
For people who are still in a life stage of contributing to their retirement or investment accounts, we talk about buying funds in a down market as being “on sale.” Similarly, doing a Roth conversion when your portfolio value is lower gets a bigger portion of your money into the Roth bucket while paying the exact same tax bill.
Consider a fictional portfolio worth $100,000 on January 1st. Let’s say you have $50,000 each in a traditional and a Roth IRA that are invested in the same funds. If you convert $10,000 from your traditional IRA to your Roth, you owe taxes on $10,000 of income, and you now have $40,000 in your traditional IRA (40% of your money) and $60,000 in your Roth IRA (60% of your money).
Alternatively, if you wait until July 1st, the portfolio value has dropped to $80,000, so you now only have $40,000 in each account. Converting $10,000 to your Roth costs you the same tax bill, but you now have $30,000 in your traditional IRA (37.5% of your money) and $50,000 in your Roth IRA (62.5% of your money).
Let’s say that by December 1st the value of your portfolio has climbed back to $100,000 again. Your January 1st conversion would leave you with $40,000 in your traditional IRA and $60,000 in your Roth IRA, while your July 1st conversion would leave you with $37,500 in your traditional IRA and $62,500 in your Roth IRA. You’ve sheltered an extra $2,500 from future taxes for the same price.
Is a Roth conversion a good idea for me?
To perform a Roth conversion, you must have a traditional IRA account. If any of the following describe you, a Roth conversion may be a good fit:
You are early in your career and expect to make more in the future.
You are taking a sabbatical, working part-time, or have an abnormally low income year.
You have retired but have not yet started taking Social Security.
You have retired but are not yet RMD age (72).
You are considering moving to a state with a higher income tax rate.
You have some extra savings that can be used to pay the income taxes owed.
And by the same token, these factors may point against a Roth conversion being a good fit:
You are near the height of your career, so sheltering income from taxes is more important.
You expect your income to go down soon, due to retirement or a job change.
You are considering moving to a state with a lower income tax rate.
You don’t have much in cash savings to pay the income taxes owed.
If you are interested in discussing whether a Roth conversion might be a good fit for your financial plan, please feel free to reach out to us.