In this episode of the Life and Finances Together podcast Roger and Jake discuss the many things to consider when choosing to do a Roth Conversion and what can often be missed in the decision.
Roth conversions are the new buzzword. They are a frequently discussed financial planning strategy that everybody seems to want to know about and actually want to complete.
But there are a few things you've got to consider before you start doing the Roth conversion. We know it's a very popular strategy, but there are a lot of things that can go wrong, and investors can get into financial trouble and maybe even a little bit of trouble with the tax man, which leads to the first big consideration, and that's taxes.
So when you're considering doing a Roth conversion, the first thing you need to look at is taxes from a number of different perspectives. You have to consider, first and foremost, how much of your traditional IRA money are you going to convert to a Roth IRA? To find out you’ve got to factor in your income taxes. Starting with your federal income taxes.
Because converting is a taxable event, if you are thinking about converting a large lump sum in the current year, it may not be the best strategy because you're going to run up the tax schedule and put yourself into a much higher tax bracket. So typically, the better strategy is to convert this IRA money to Roth money over a period of time.
To determine what makes the most sense, you really need to reference the federal income tax brackets. You need to look at each bracket and see, based on your tax return, where you sit. You can look at last year's, but also need to project where you're going to be this year with the amount of income that you know that you will make.
And what we often will implement for clients is “running up” the tax schedule, filling in their current bracket. So if they're $20,000, $30,000 into the 12% tax bracket, well, we're going to see how much we can convert while still keeping them in the 12% tax bracket so that they are not paying extra income taxes on the conversion. You can see how much income you have available in each one of the brackets. So, you need to be aware of that. And it is something that you have to reference every year because the amounts that go into each tax bracket can change annually. The standard deductions can change, your income can change, et cetera.
So remember, you’re not just thinking about the year you are beginning your conversion, you have to look into the future as well. You could have more income coming in in future years.
If you're still working and you expect pay increases, large bonuses, or commissions. If you’re going to be retiring or are newly retired, you might be in a lower tax bracket. You're not going to be earning the same amount of income that you've been earning. You may be enrolled in social security, and you withdraw less money in retirement. Well, you may be in a lower tax bracket.
Thinking about the big picture: our country has $35 trillion of debt that continues to grow and some president down the line is going to have to raise our income taxes. We hear this concern often, but we don't know for sure if or when that will happen. We can only work with what we know.
So this is what we call in finance an arbitrage opportunity. You want to pay the taxes on this money when you think that you're going to be in a lower tax bracket.
And all that we know are the knowns. We know what the current tax law is. We know that if nothing changes in the short term, the current tax law is going to sunset and tax brackets would change. So we really focus on each client’s specific income tax situation. And it is different for every client because every situation is different.
If you know, for example, that you're going to be making less money next year, you may want to wait until next year to do some of this conversion because you can fill up the tax bracket a little bit more. You can convert a larger amount of money. If you know you're going to be making more income next year, then you may want to convert more in 2024.
So federal taxes are a major consideration, but you also have to factor in your state income taxes. Each state has different rules for income taxes. If you know, for example, as a retiree, that you're going to be relocating to Florida from Michigan. You're moving from a state that has state income taxes to one that has no state income tax. So that should impact your Roth conversion planning. If you’re moving to Florida, you may want to wait until you’ve completed that move and you’re not going to have to pay any state income taxes on that conversion.
But there are even changes coming soon in the state of Michigan to tax laws. There was a four-year phase out of taxation on withdrawals from 401ks, IRAs, and pensions. And in 2026, there will be an elimination of state of Michigan income tax on those withdrawals.
So if you're ramping up now and thinking, well, I'm going to convert a whole bunch of money from my traditional IRA to a Roth right now. You may want to consider waiting.
It depends on the amount that you're going to convert and what taxes you pay to the state of Michigan when you actually do the conversion.
And this is something that can get missed because investors may only be considering the federal tax implications. You need to remember state taxes, too. They have different ways of looking at Roth conversions and how they're going to be taxed. So you're going to have to understand what's going on with your state.
It all always comes down to taxes and then taxes and then taxes again.
So just because everybody's talking about it and everybody's saying that it's going to be the best thing for you to do or your family to do. You still want to take the time to analyze all of the factors involved to make sure that it really is right and when it would be most advantageous for you. You’ve got to do the math first before you're going to do anything. That's the most important thing.
But if you're in the state of Michigan, you should coordinate with your tax advisor to see what the best timing may be to do any kind of sizable conversions given there's no more state of Michigan tax on 401k, and IRA withdrawals and also on pensions. It’s a pretty big deal that people are missing.
This coordination with taxes really is to avoid converting too much at one time. You want to make sure that you're not converting too much that could drastically impact your income taxes. So in many cases, it's going to make sense to do the conversion over a period of time.
Another thing that is important to consider is your cash flow when thinking about doing a Roth conversion. You’ve got to make sure that you're not going to put yourself in an adverse situation by increasing your tax bill with the conversion, especially if you're retired, from a cash flow standpoint. Do you have liquid savings? Do you have savings outside of IRAs? You're going to want to know your numbers so you can pay your taxes.
One of the major things that regularly gets missed, and it gets a little bit technical, is the pro rata rule. This relates specifically to Backdoor Roth IRA conversions, which are usually applicable to high income earners. Those that can't contribute to a Roth because they just make too much money. High income earners do not receive certain federal opportunities like being able to contribute to a Roth in the traditional sense.
So, what a lot of high income earners are doing is taking some of their money and putting it into a traditional IRA. They don't get a deduction for this new account. And that happens on Monday. And let's say they invest seven thousand dollars. They put seven thousand dollars into the IRA with the idea that on Tuesday they would convert that traditional IRA to a Roth. This is called the Backdoor Roth IRA conversion. There are no earnings because the IRA was just opened. So it seems like a great idea. They are able to get money into a Roth and it's going to continue to grow tax free just like what anyone else can do.
Not so fast, because the IRS says, we’ve got this little thing called a pro rata rule. And what that means is they're going to look at all of your retirement assets. They're going to look at your IRA, simple IRA, your SEP IRAs, and they're going to add that together with any after tax accounts, basically the Roth that you have. And they're going to look at what the ratio is between pre-tax versus after tax dollars.
For example, you have a million dollars in retirement assets, 900,000 of it is in IRAs, SEP IRAs, or Simple IRAs. This doesn't apply to 401Ks or 403Bs, major plans that you have through your employer. The IRS is just looking at those IRA type of assets where it's all pre-tax dollars. So you have 900,000 out of a million in those IRAs and 100,000 is sitting in the Roth. Well, that's a 90% ratio of pre-tax versus after tax. So when you do a Backdoor Roth conversion of $7,000, $6,300 will be included in taxable income. And it’s double taxed.
Can you believe it? I mean, that's incredible. That's double taxation. It's a huge thing that's often missed.
But let's say, you’re okay with double taxation and all of the IRS rules. You still need to track those taxed funds. You're going to have to make sure that you're on top of these things for future years.
Moving away from the Backdoor Roth, let's just say you're coming with a perfect plan.
You're factoring in all the taxes. You understand what your state income taxes are going to be. But you don’t have the cash to pay the tax bill on the conversion.
The best scenario for completing a Roth conversion is to have cash saved up to pay for the taxes due. And that was the original idea. That's how the Roth strategy came about. But now that this Roth conversion is such a big buzzword and everyone's trying to build it into their financial plan and implement it, a lot of people have not saved up enough cash to pay that tax bill. It's not as advantageous when you don't have that cash because you're going to have to pay for the taxes out of the converted amount. Which isn’t the ideal option.
For example, let's say that you determine you want to convert $10,000 from your IRA to a Roth. Through all the math that you've done, and all the planning, $10,000 is your sweet spot, but you don't have the cash to pay for it. What you'll have to do is convert $10,000, but also withhold your federal and possibly state income taxes before it goes into the Roth so you can pay the tax bill. Now what was $10,000 of IRA money is now $7,000 of Roth IRA money. So you can just see there by the basic math, you're kind of taking a step backwards in your investment. You've got less retirement assets that are moving into this Roth, fewer shares, and you've got less of a balance of the account that will continue to grow compounding later into your retirement.
If you've got to pay for the conversion through tax withholding instead of paying cash for it, dollar for dollar, you've got less funds inside of this Roth IRA that won't grow as fast over time.
Fir retirees, another thing to consider is that you may be depleting your cash reserves by converting in an effort to pay the taxes. Even if you have the cash to pay the taxes, you may need to coordinate that with what your standard of living needs are to make sure that you aren’t going to be short on funds to pay your regular bills. Because what we're going to try to coordinate is the use of some of your liquid savings, along with IRA withdrawals, to potentially keep you in a lower tax bracket for the first years of your retirement. And if you start using too much cash, now all of a sudden all you have left is IRA money. So you've got to be careful with what you're doing there.
We talk a lot about taxes, but doing a Roth conversion has to coordinate with your financial plan and what your needs are going to be when it comes to your cash flow and your lifestyle goals.
We can’t address the things missed when considering Roth conversions without talking about the five-year rule. You may have heard about it, but just to clarify, when you open the Roth IRA account, you have to wait five years before you can withdraw the earnings tax-free. This is widely known. But what gets missed is that the five-year rule applies to each conversion.
The clock doesn’t only start when you open up the IRA to complete your first conversion. Every conversion you do in that Roth IRA gets a separate schedule. So does that mean? You need to track each conversion date. For example, you decide that you’re going to be doing this over a 10-year period of time. If, at any point, you want to start withdrawing within that 10-year period, you're going to have to figure out how much you’ve converted and how much is eligible for withdrawal on a tax-free basis and how much isn't? The IRS won’t do this for you. So it’s important to consider this and to be prepared to get organized!
Then there is the issue of Medicare. If you're retired, doing a Roth conversion could cause you to pay higher premiums.
This conversion is taxable income, which not only affects how much you're paying in taxes, but can also impact social security taxation, and can factor into the calculation of your AGI, which determines how much you're paying for your Medicare premiums. So if you convert a large sum of money from IRA to Roth in 2024, and you've increased your adjusted gross income by a certain dollar amount it may cause you to exceed the threshold for your Medicare Part B or D premiums. Doing this means you may have to pay an extra surcharge, or this IRMA, on your Medicare premiums for an entire 12-month period of time. But it doesn't happen right away. It takes about a year for the Social Security Administration to catch up with you as it relates to this.
So, when you look at doing these Roth conversions, no matter what strategy you're adopting or what methodology you're looking at, whether it’s doing it gradually, or you're looking at possibly a backdoor, there are so many variables, so many different tables that you actually need to be aware of! As you look at this strategy, is it an effective strategy? It could very well be.
You’ve just got to be mindful when you're running the calculations, when you’re doing the math, that anything's going to look good the longer that you live. Because you’ve got more time to make up for a possible mistake that you made. And there should be some kind of breakeven analysis that you check. A lot of times when we do the math for clients, at end of life, and we project out in our financial plans to age 90, folks actually will have a smaller capital base than if they did no conversion. It'll be smaller. But then when you peel back that onion a little bit you see that while the total capital base is a little bit less, you might have 90% of that capital base that is not subject to any taxation.
Implementing a Roth conversion can get complicated. You have to do the math. You have to do the calculation. And what your neighbor's doing is not necessarily what you should be doing. Everybody's situation is different.
If you're not doing the math and looking at what the impact is on your financial plan, then you could get yourself into trouble, both from a taxation standpoint and also from your financial well-being and your cashflow situation. Be careful. Understand what the impact is on your individual situation and always do the math.
Thanks so much for reading and for learning more about the do's and don'ts of Roth conversions today. If you have any questions about this topic, our financial services, or finances in general, please send us an email or give us a call.
