Tax Strategy – Roth Conversion

by | Dec 15, 2020 | Investing, Smart Financial Tips

Investors often focus on the daily moves of the market, economic predictions, or the S&P 500’s performance when they think about their investment returns. These are things an individual investor cannot control, yet we spend so much time worrying about them! While it may not be as fun or emotional as watching the stock market, tax planning is one way investors can attempt to maximize long-term investment returns. Even better – it’s something an individual CAN control. Roth Conversions are a strategy being talked about a fair amount today to improve after-tax returns given the potential for tax rates to go up in coming years.

Pre-Tax vs. After-Tax Retirement Accounts

In a Traditional IRA or 401(k), money that is contributed to the account is considered “pre-tax” –the account holder is not paying tax on that money in the year of the contribution because the contribution is tax-deductible. The growth on the investments is tax-deferred as the funds are later taxed when the individual withdraws or distributes money. At age 72, an individual must begin taking Required Minimum Distributions (RMDs) from a Traditional IRA or 401(k).

In a Roth IRA or Roth 401(k), money that is contributed to the account is considered “after-tax,” meaning the account holder is paying tax on that money in the year of the contribution—there is no deduction for it. Growth on investments is tax-free, and when money is withdrawn, it is not a taxable event as long as the individual makes a qualified distribution from the account. Other advantages of Roth IRAs are that the individual is not required to take RMDs (unless left in a Roth 401(k)), and account holders can leave tax-free money to their heirs.[i]

Pre-tax and after-tax accounts both have their advantages. Timing and individual circumstance can determine which vehicle is right for an investor in a given year.

Roth Conversions

A Roth Conversion allows someone to move money from a Traditional IRA or a 401(k) to a Roth IRA, with one catch. The account holder must pay tax on the amount of the conversion, essentially turning pre-tax money into after-tax money.  When might it be beneficial to do this?

It usually makes sense to perform a Roth Conversion if you expect your tax bracket to be higher in future years than it is in the current year. For example, if my tax bracket is 10% today and I expect it to be 24% in all future years, it may make sense for me to pay tax on the money today rather than waiting and paying at a higher rate later.

Current tax law sunsets in 2026, and many expect tax rates to rise at that time, if not before. Also, the CARES Act waived Required Minimum Distributions in 2020, so many people will have lower incomes than they would in most years. These are two considerations that could make a Roth Conversion more attractive in 2020.[ii]

Strategies

Many people choose to do Roth Conversions in between the years in which they retire and age 72. Often, someone’s only income during this time is Social Security or pensions. At age 72, individuals must begin taking Required Minimum Distributions from their pre-tax retirement accounts, potentially boosting their income into a higher tax bracket than a few years before.

If you’re in the giving mood, another strategy is performing a Roth Conversion in the same year as a deductible charitable gift. The deduction obtained through a gift to charity or a Donor Advised Fund can be used to help offset some of the tax liability created by the conversion.[iii] An individual also has the option to pay the tax created by the conversion with a non-retirement account, allowing the investor to preserve their tax-deferred retirement assets.

All situations are unique—please reach out to your advisor if you have questions on whether a Roth Conversion makes sense for you. The correct use of this tax planning transfer can save substantial money over time and enhance an investor’s after-tax return.

[i] YouTube, https://www.youtube.com/watch?v=eprcceo6vVo&feature=youtu.be Accessed 8 Dec 2020.

[ii] Stein, Mark. Kiplinger.Com, 2020, https://www.kiplinger.com/article/retirement/t046-c000-s004-a-great-year-for-a-roth-conversion.html  Accessed 8 Dec 2020.

[iii] Laughton, Kim. “Why 2020 Is An Especially Good Year To Give”. Schwab Brokerage, 2020, https://www.schwabcharitable.org/content/why-2020-is-especially-good-year-to-give  Accessed 8 Dec 2020.

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