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Explainer Video: The Benefits of Roth Conversions

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Learn How You Can Potentially Reduce Taxes on Account Distributions


On today’s whiteboard series I want to talk about Roth conversions and adding value to your portfolio over time, by reducing the amount of taxes you pay when making distributions from your retirement accounts. A Roth conversion is simply the process of converting assets from a pretax retirement account, such as a 401k or traditional IRA and moving those assets over to a Roth IRA, which is a retirement vehicle that will grow in compound tax free throughout the rest of the account owner’s life. So let’s say you’ve spent your entire working career building up your retirement savings portfolio, doing it mostly on a pretax basis, saving money into 401ks or other employer retirement plans. And you’ve built up this big bucket of retirement money that’s currently all pretax status. So you have this, let’s say traditional, you’ve consolidated everything. You’ve got this traditional pretax rollover IRA.

So a Roth conversion would involve setting up a Roth IRA, if you don’t already have one and starting to convert assets from the pre-tax account, either lump sum or systematically and moving them over into a Roth IRA. So the amount that you take out of the pre-tax account is taxed as ordinary income. But once that money is reinvested back into the Roth IRA, it will grow and compound on a tax free basis throughout the rest of the account owner’s life. Also, once the assets are in a Roth IRA, you no longer are required to take distributions from assets in a Roth IRA, unlike a pre-tax IRA, where you need to start taking required distributions at age 72. You never in your lifetime have to access the assets in a Roth IRA. And so they can grow and compound for decades. You can take them out tax free later in your life, but also you can leave them to your kids or grandkids.

So it becomes a nice estate planning vehicle, as well as sort of some income tax planning strategy. So why would someone explore Roth conversions or conversely, why would someone not do this if flipping money from a pre-tax account and put it into a tax free account has so many benefits. Well, essentially it comes down to one thing and that’s taxes. We know that at some point in our lives, when we have money in a pre-tax retirement account, we have to take distributions from it. So a Roth conversion is going to look at your current tax situation and try to model and see if you think that right now, you’re going to be in a lower income tax bracket than you are going to be later in life when you have to start taking the money out.

So there’s never a known answer, because tax rates can always change. They might go up or down in the future. And we have limited visibility as to what that might look like, but we can be very educated in our analysis of this to see if we think it might make sense to take money out in a particular year and flip it to a tax free Roth IRA. So let’s say you are someone that’s working. You take a year off or some sabbatical. Your taxable income goes to zero. That could be an example where you look at pre-tax retirement assets and decide to flip a portion of those into a Roth IRA. Maybe you’re a business owner and you have a year or two where, because of some business accounting, you find yourself with losses and you’re not reporting much in the way of personal taxable income. You could explore then maybe getting money out of pretax retirement accounts because you’re going to be in a lower income tax bracket as well.

But by far the most common scenario where we see Roth conversions is following one’s retirement when their income goes from, their wages or whatever they’re making to near zero. And they have this window of time from the time they retired before they start receiving social security and before they reach an age currently 72, when they have to start taking money from their pre-tax retirement account. So quick example of that. So right now, based on the current tax tables, income tax brackets are 10%, 12%, 22%, 24%, 32% and so on depending on what your income is, obviously the tax rate goes up as your income goes up. And so these are the current tax rates. And let’s say that your someone that’s worked for the past 40 years and here they are at age 60 planning to retire in the next year or two. And we’re kind of looking out over the next 10, 12 years till their age 72, which is the current age for requirement of distributions when we know we have to start taking our mandatory distributions from retirement accounts.

And so this person at age 60, they’re still working, they’re in their peak earning years. And so we find them in a higher income tax bracket. Age 61, they’re still working, maybe they’ve got some other portfolio income, but they find themselves in a similarly high income tax bracket. But their plan is to retire at age 62. Let’s say January 1st for purposes of this example. And at that point, their income is going to go way down because they’re no longer working and maybe they just have a little bit of portfolio income. And so that’s going to be the case in ages 63, 64, 65 and 66, where they’re going to just have no working income. They don’t have pensions or any other passive income. And their portfolio just kicks off a little bit of interest in dividends, maybe capital gains.

At age 67, all the way up to age, 72, 68, 69, 70, 71. Let’s say that this individual has decided that in addition to their everyday annual portfolio income, they also want to start receiving their social security benefits, which is a whole separate analysis. But again, for purposes of this example, we know that that will come in at some point later in their 60s. And then finally based on current law at age 72, they’ll have to start taking distributions from their retirement accounts and then going forward from here, we’re going to have portfolio income, social security and RMDs. And so what this looks like here is a window of opportunity for Roth conversions because they’re going from a really high income tax bracket to a temporary window of being a lower income tax bracket knowing that at some point they’re probably going to revert back to being in a higher income tax bracket. And so this is where you can really model out and try exploring if it makes sense to take money out of a traditional pretax IRA and flip it into a Roth IRA.

So you would look at this example here and decide that working with the CPA, always doing good analysis, perhaps that you think you want to stay below the 22% income tax bracket. So you’ve done some analysis and you’ve said, you know what? We can take $50,000 a year out of our pre-tax IRA over the next five years because there’s going to be this window. And then income’s going up again in the future. And so this is what the Roth conversion window in amounts are going to look like. So each year you go back, you work with your CPA and you just systematically start taking money out and flipping it over into your Roth IRA, because the amount of tax you’re paying on this is going to be lower than what you’re paying in the future.

And so again, you can see how over time, not insignificant amounts converted from a pre-tax retirement account, getting them out, paying some small taxes and then getting the tax free IRA is going to add value to your portfolio because you’re going to pay less in tax. You’re going to reduce the value of your IRA, which is subsequently going to reduce the amount of future required minimum distributions. And this is really just a way that you can keep more of what’s yours by simply playing with some different levers, with respect to tax rates and projecting future tax rates. So you can add value to your portfolio. It doesn’t involve taking any more risk in the investment allocation. It doesn’t involve being a market genius and getting in and out and avoiding volatility. It just simply involves the exercise of lowering your taxes, looking at things like costs, lowering those and keeping more ultimately of what’s yours.

So finally, one thing to know as we sit here in 2022, amidst some market volatility, market volatility, downturns in the market present a fantastic window in addition to looking at the tax analysis for Roth conversions. So as the markets go down, asset values in these pre-tax retirement accounts go down as well. We can then take some of those at lower depressed values, flip them over into the Roth and then over time, whenever the market’s recover, whether it’s next month, next year or few years down the line, they can then do so in the shelter of a tax free Roth IRA.

And so we always want the tax analysis to lead the Roth conversion strategy. But if you can concurrently do it in a down market as well, you can just add a little bit more value to your portfolio. So Roth conversions, there’s something you need to be very intentional, proactive with. It requires a lot of thought and analysis, consultation with your advisor and your CPA, but it’s a very powerful strategy for the right individual or family to leverage current tax rates against future tax rates and get money out on a real tax efficient basis from pre-tax accounts, flicking them into retirement accounts, which is just going to systematically and sequentially add value to your portfolio over time.

This commentary is provided for general information purposes only, should not be construed as investment, tax or legal advice, and does not constitute an attorney/client relationship. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.


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