Updated: Jul 14, 2021
As the year draws down, many are considering the possibility of higher tax rates in the future, both as a result of paying back the stimulus enacted earlier this year and as a possibility should Biden win the White House. If you believe that higher tax rates will be implemented in the future or even think you may find yourself in a higher bracket in the future due to lower income now and increased income in the future, it may make sense to execute a Roth conversion. In doing so, you essentially pay taxes on the converted amount now at your present tax rate, allowing the money to grow tax-free in the future when your rate may be higher. If you’re considering this tax planning opportunity, there are a few things to keep in mind.
1.) Your future expectations
While you may be expecting higher tax rates in the future, if you also expect to have a lower need for income in the future, a conversion may end up being a wash. Working with a financial planner on building out a cash flow plan can help you best navigate this question. During that process, you may also want to consider your Requires Minimum Distributions (RMDs) and whether a conversion now can help you avoid larger RMDs that could potentially push you into a higher bracket in the future.
2.) The beneficiaries on your account
If you plan on leaving your account to a child or grandchild, you may also want to consider their tax position. If they are in a low tax bracket and expect to be in the future, a conversion may not make sense. Conversely, if they’re in a high tax bracket, it would be advantageous for them to inherit Roth money instead of traditional IRA money. Similarly, if you’re planning on leaving your IRA to a charitable organization, a conversion doesn’t make sense as the money won’t be taxed if left to a qualified organization. If this is the case, you may also want to consider making Qualified Charitable Distributions from your plan during your lifetime to get the tax advantages while you’re alive.
3.) What is your time horizon
The length of time you expect your Roth account to grow should also be a factor in your decision. The younger you are, the more it may make sense to execute a conversion as it will leave a longer time horizon for your Roth account to grow tax-free. Additionally, it would help if you also consider how soon you might need to draw on the Roth account, as the five-year rule will preventing you from accessing your converted funds in the first five years following the conversion.
4.) Do you have the cash to pay for the taxes
In a Roth conversion, you pay the taxes on the amount converted. This means that to execute the conversion, you need to have cash available to pay those taxes. How much you’ll need to pay will depend on how much you convert as well as your federal and state tax rates. It is also possible to pay your taxes from the IRA during the conversion, but you will essentially end up having to pay additional taxes on the money you pull to pay the taxes.
Finally, should you decide to enact a Roth conversion, it’s essential to be mindful of your current tax bracket. Because a conversion is considered taxable income to you, you don’t want to convert so much that you end up bumping yourself into the next tax bracket if that's something you're trying to avoid. To this end, it’s always a good idea to consult your financial planner and accountant regarding the specifics of executing a conversion.
To learn more about year-end tax planning ideas, be sure to tune in on October 29th when CPA Tim Savage joins us to talk about the current state of tax law and how we can make the most of our personal wealth when it comes to our taxes. To learn more about our Informed Investor webinar series and to register for updates, click here.