5 Life Events That Present Ideal Opportunities For Roth Conversions. And 3 Things You Should Always Consider Before Converting.
***Transcript***
(Edited for clarity and grammar.)
Are you worried about future tax hikes eroding your retirement savings?
What if you could strategically convert your pre-retirement accounts into Roths and lock in tax-free growth for the rest of your lifE
In this video, we'll explore Roth conversions, an essential strategy for anyone serious about maximizing their retirement accounts. Specifically, we'll examine five life events that might provide great opportunities to convert.
Make sure you stay to the end when I discuss three important factors you should consider before making any Roth conversions.
Hi! My name is JP Geisbauer, founder of CenterPoint Financial Management. I'm a certified financial planner professional and a certified public accountant, and this channel is dedicated to helping diligent savers maximize their lives and minimize their taxes as they transition into retirement.
Before diving into situations that may provide good opportunities to do a Roth conversion, let me describe how they work. Say you have a pre-tax balance in your traditional IRA. A pre-tax balance means you claimed a tax deduction in the year you funded the account. By making this pre-tax contribution, you will be taxed when you take money out of the account. Depending on when you were born, you will be forced to begin taking required minimum distributions at either age 73 or age 75. Not taking a distribution from these accounts is probably not an option.
During a Roth conversion, funds are moved from the pre-tax account to an after-tax Roth account. Ideally, this would occur via a trustee-to-trustee transfer where the balances are transferred from one custodian to the other without you ever taking custody of the funds.
For income tax purposes, you will recognize ordinary income on the conversion amount and have to pay the related income tax on that amount. However, once the funds are in their Roth account, they're allowed to grow tax-free. Additionally, any withdrawals are considered tax-free as well as long as you're over 59.5 and the account's been open for at least five years. Finally, are no RMDs required for a Roth IRA for the original account holder. These three aspects of the Roth account make them an incredibly valuable retirement planning tool.
Now that we generally understand the mechanics of a Roth conversion, what are some life situations that may provide an excellent opportunity to actually do a Roth conversion?
1. A low-income tax year
A year in which you have abnormally low income could provide an excellent opportunity to do a Roth conversion. Some of these events may be unplanned, making a Roth conversion more difficult. For example, if you lost your job or were a business owner and had a really difficult year. While these lower earning years provide a great opportunity to do it, they might be difficult to plan.
However, there are certain situations where you can plan around a low-income tax year. Say for example you want to take some time off from work to either travel or get an advanced degree. Or take some time off. Take a sabbatical. Take a rest. You can use that lower-earning year to do a Roth conversion.
If you're planning to have children and one of the spouses wants to stay home with the children, there might be a couple of lower-earning income years when only one salary comes in.
Another situation could be when you're planning on launching a business and realize it might take you a year or two to get it off the ground. At that time, you might have a low income or even be running the business at a loss. This provides a great opportunity to do a Roth conversion.
If you find yourself in a low-income year, or better yet, you can structure a low-income year in the future, you may want to consider how you can do Roth conversions.
2. Delaying Social Security
I've made a video on the benefits of delaying Social Security. I'll include a link to that video in the description below.
But for the purpose of this video, you can claim social security between the ages of 62 and 70. The longer you wait to claim Social Security, the higher your benefit will be. In the years you're waiting to claim Social Security, you might be in a lower tax bracket. Being in this lower tax bracket might provide a great opportunity for a Roth conversion.
3. Time Between Retirement and Taking RMDs
I've made a video on how to reduce your required minimum distributions, so I'll include a link to that in the description below.
This is a similar concept to number two above in that you're going to have a period between when you retire and when you're going to be forced to take required minimum distributions. During that time, it's likely you'll be in a lower-income tax year. So make sure you take advantage of the years between when you retire and when you're forced to take RMDs because there could be some lower earning years, which provide a great opportunity to do a Roth conversion.
4. During A Market Correction
When people are panicking, refusing to look at their retirement accounts, and wanting to sell everything and go home, this is an excellent opportunity for cooler heads to prevail and do a Roth conversion.
Let's go through an example of how this might work. Let's say you own 1,000 shares of ABC Corporation. Before the correction, ABC Corporation was $100 per share. To do a Roth conversion of that entire position, you would have been forced to recognize ordinary income of $100,000. But let's say ABC company gets whacked by 50%, and now it's trading at fifty dollars a share. At $50 a share times 1,000 shares, to convert that entire position, you would recognize $50,000. By converting that position when the value is depressed, you reduce your taxable income by $50,000. And, once that position is in the Roth account, it's able to grow tax-free for as long as you hold it.
By staying calm, cool, and collected when everybody else is panicking, doing the Roth conversion in a down market can be a smart and savvy strategic financial planning move.
5. Your Children Have A Higher Tax Rate Than You
Believe it or not, Roth conversions can also be an effective estate planning strategy and a very effective tool for intergenerational financial planning.
I've recently had a couple of clients inherit their parents' IRAs. Generally speaking, when you inherit an IRA from your parents you're going to have 10 years to zero that account out. But the problem is my clients are inheriting these accounts in some of their highest-earning years.
My clients didn't have any intention of stopping working. They enjoyed their lives, their work, and what they did. So, given how sizable these IRAs are, having to recognize all of this income within 10 years is creating a bit of a tax problem.
Given this example, it may make sense for the parents to recognize the income at their lower income tax rates than for the children to recognize the taxable income within the 10-year period after inheriting the IRA.
This is going to take a little bit of work, and you'll need to communicate between the two generations to figure out if this is the right strategy for you. But it may make sense for the parents to do the Roth conversion, recognize the income tax at their rate, and then let the kids inherit the assets tax-free.
Okay…So there you have it, five potential life situations that could occur and provide an excellent opportunity for Roth conversions.
So now that we've gone through those particular scenarios, what are the three important considerations you should consider before doing a Roth conversion.
The first is income tax rate arbitrage. Now that's fancy pants finance talk for essentially saying, does it make sense to pay taxes now or pay taxes later based upon where you think the income tax rates might be. Given the fact that you are going to have to take the required minimum distributions, you're going to have to recognize this income at some point in time. Or your kids are going to inherit your IRA, and they're going to have to recognize the income.
So, by taking a longer-term view and considering the possible tax rates throughout the rest of your life, it may make sense to start making Roth conversions earlier than you might normally think.
Number two, ensure you have enough cash outside of the IRA to pay for the taxes on the Roth conversion.
You will want to maximize your Roth conversion by getting every dollar of that conversion into the Roth account. To do that, you will have to have cash outside of the traditional IRA to pay for the taxes to do the conversion. So, if you plan on doing one of these, make sure you've planned around how the related income tax consequences are going to affect your personal cash flow.
Number three, this isn't an all-or-nothing strategy. You'll want to look at this annually with your CPA or financial planner to see if Roth conversions make sense. Again, you don't have to do all of the account or most of the account. Heck, you don't have to do any conversions at all if they don't make sense.
But if you start actively looking at your tax rates and beginning to see your lifetime tax bill, your perspective may change. You may realize that doing Roth conversions during years of the previously mentioned life events can save you and your beneficiaries' taxes throughout your lives.
Again, don't think you've got to do everything. This can be effective through small conversions or significant conversions, as long as you're consistent and it is part of your overarching retirement plan strategy.
That concludes this video for today. Thank you for watching. If you enjoyed this content please hit like or subscribe below. Thanks again for watching, and I'll see you next time.
About the author:
JP Geisbauer is a Certified Public Accountant, a Certified Financial Planner ®, and the founder of Centerpoint Financial Management, LLC, a financial planning, investment management, and income tax planning firm located in Irvine, CA. JP Geisbauer is dedicated to helping California-based business owners and executives transition into retirement. He has been quoted in many news outlets including Forbes, Newsweek, US News & World Report, MarketWatch, YahooFinance, CNN and NerdWallet.
Need help with your transition into retirement?
Learn More About Our Services or Schedule Your Free 30-Minute Retirement Planning Consultation
Disclaimer:
This article is for general information and educational purposes only. Nothing contained in this article constitutes individual financial, investment, tax, or legal advice. Before taking any action on any topic discussed in this article, consult with your own financial planner, investment advisor, tax professional, and/or attorney for advice on your specific situation.