Three reasons to do Roth conversions in your peak income years

VaselineAugust 10, 2024

0 4 minutes read

Three reasons to do Roth conversions in your peak income years

Every week, I buy a bag of coffee from Whole Foods. Always looking for a bargain in an otherwise expensive environment, I look for the yellow tags. Those yellow tags are easy to understand: This normally $10 bag of coffee is on sale for $7 until next week, when it’s back to $10. Typically, there are years in your life where your taxes go up because your income goes down. This is usually the sweet spot for Roth conversions.

(Warning: This article gets a little technical. See my article Roth Conversions: The Case for and Against Them for a primer.)

Now imagine a scenario where Whole Foods has both red labels and yellow labels. Red labels are the opposite of yellow labels. They denote a temporary increase in price. Think about cars and eggs in 2021. In this example, the bag of coffee costs $12 and will drop to $10 next week. Most people should and will skip this week. The same is true for Roth conversions. If you anticipate that tax rates will decrease, why would you choose to pay taxes at today’s higher rates? Below are three possible exceptions to the rule to consider.

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1. Pessimism about future tax rates.

Every insurance salesman in America will tell you why future tax rates will go up (and therefore you should buy permanent life insurance to cover that risk). Their motivation aside, some of their points are hard to argue with.

The current personal tax code is set to expire, or “sunset” in tax jargon, on December 31, 2025. At that point, marginal rates will increase. It doesn’t necessarily mean you’ll pay more in total tax, but it could increase the cost of Roth conversions.

As of today, according to US Treasury data, the national debt is about $35 trillion. There are too many zeroes to write. There are two solutions here: increase income or reduce expenses. Spending is like a tie. It moves in one direction. So we probably need to find ways to raise revenue, which leads to taxes. If you’re pessimistic about future tax rates, a Roth conversion is a way to lock in today’s marginal rate to avoid paying more in the future.

2. Significant savings in pre-tax accounts.

You are a good earner, which has allowed you to be a good saver. Let’s say you’re 55 years old and earn $250,000 a year. You saved $2 million in pre-tax accounts. If you earn 7.2% per year between now and mandatory distributions at age 75, your retirement account balance will be about $8 million. Using round numbers, if you withdraw 4% in the first year, your RMD will be $320,000 in the first year, which will likely send your tax rate above where it is today.*

I could argue that you should wait until retirement to take advantage of much lower rates. However, it may make sense to only convert to the top of your current income tax bracket if you know your future marginal rate will increase.

Your financial plan should contain a tax projection. If your counselor hasn’t done this for you, ask them to. If you want to build your own plan, you can use this free version of our planning software.

3. Your heir’s tax rate is higher than yours.

About 10 years ago, I met with a potential client who lived in Washington, DC and was in his prime earning years. He insisted on doing Roth conversions. On the surface, given that it was a few years away from falling rates, this was a bad idea. After digging deeper, it was obvious that leaving a legacy for his son was a priority. Ironically, his son was one of Facebook’s first employees and already rich. His son was still working and earning many dollars as a California resident.

It’s not my role to question his goals – just to help him achieve them. At this point, the Roth conversion calculation switches to the current rate versus his son’s future rate. Income tax rates in Washington are high. California income tax rates are higher. The client’s income was high. The son’s was much bigger. The total tax paid today will be less than the rate paid later.

There are exceptions to every rule. The rule of thumb for Roth conversions is trusting that today’s rate is lower than tomorrow’s. If you’re close to retirement, your rate once the income goes away may be lower. Again, lean on your financial planner and their tax projections to give you an idea of what your current and future rates look like.

* This hypothetical example is for illustrative purposes only and is not intended to be representative of actual results or any specific investment, which will fluctuate in value. Please note that you may lose money investing and actual results will vary.

This article was written by and represents the views of our contributing advisor, not the Kiplinger editorial staff. You can check advisor records with help dry or with FINRA.

VaselineAugust 10, 2024

0 4 minutes read

Vaseline

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