End-of-year planning has officially begun. My days are filled with questions about tax loss harvesting, end-of-year retirement contributions, and a plethora of inquiries about Roth conversions.
It’s always been my preference here on Thoughts On Money to tackle the “softer side” of financial planning, and I typically veer away from the more technical or nuanced topics. Primarily because these topics can be a bit of a snooze for the average reader, I hope you would collaborate with your advisor/CPA/attorney for that type of personalized technical planning. My real aspiration as a personal finance writer is to teach you how to think.
With that said, I’d like to talk about a more technical topic today – Roth conversions. I will keep us more focused on the why than the how, and we will dive into some of the considerations that I think are often forgotten or glazed over.
Let’s start simple – what is a Roth conversion? Under the current tax code, an investor can elect to convert a portion or all of their traditional IRA (pre-tax monies) to a Roth IRA. Each dollar converted is considered taxable income, and the benefit is that the Roth account will then grow tax-free.
Here’s the most important question to ask, why would someone elect to pay taxes today (by converting) versus deferring to pay taxes later? Because they believe the tax expense would be lower today than it will be in the future. It’s really that simple.
Here’s the hard part: how do you determine the future tax rate? This determination will be a guess. An educated guess? Sure, but a guess, nonetheless.
Here’s the approach I prefer – I assume tax brackets in the future will be the same as they are today. This is an assumption, so it could be absolutely false, but you want to isolate just one variable. We want to isolate your taxable income as that sole variable. Is there a reason to believe your taxable income will be less this year than the average year going forward? If so, this could be the type of scenario where a conversion would be attractive.
I like to think about it this way. You are going to make a deal with Uncle Sam, your silent business partner, and you are negotiating what his cut is going to be. Ideally, you want to pen an agreement where Uncle Sam gets the smallest cut.
So, what sort of things would impact your future income or tax bracket?
- If you lost a spouse this year, you would transition from married filing jointly to a single filer next year.
- If you expect a sizable inheritance in the near future, that will impact your future tax bracket.
- Maybe you are making a career change and saw a temporary dip in income.
- You have a sizable and extraordinary business loss that reduced your taxable income this year.
- You are looking over your projected Required Minimum Distributions and eyeing how that will drive you into higher tax brackets in future years.
Whatever the cause, there would need to be a strong reason to believe that your tax rate this year would be lower than expected in the future. You may want to tell Uncle Sam you will pay those taxes today in those cases.
Roth conversions can also be a consideration when you are in the midst of legacy planning. Perhaps you are trying to stay beneath the estate tax exclusion, and a conversion would help bring down your total net worth figure. Perhaps it’s not an estate tax consideration, but rather you are considering what the tax implications would be to the next generation (heirs). With the changes to distribution requirements for inherited retirement accounts – the new requirement being less favorable than the legacy rule – many investors have begun calculating the tax liability to the next generation as a motivation for a Roth conversion.
This list could go on and on for potential reasons to explore a conversion and situations where it may be suitable. I would caution you on proceeding with a decision like this without clearly mapping out the benefits and assumptions you are using to come to this conclusion. Some planning discussions will reveal that a conversion is obvious, and others will be less clear.
Let me provide a simple example. I recently reviewed a Roth conversion for a client, and based on the numbers; it looked like it made a lot of sense to convert. With a recent career transition, income figures were lower than normal, and a future expected inheritance looked sizable. The financial modeling showed that the lifetime tax expense would be reduced significantly with some meaningful conversions over the next few years. And we went through a few different potential scenarios – including the fact that if they chose to move out of state in the future, they would be locking in a state tax expense at one of the highest states in the country. This seems like a scenario where many planners would conclude this as a “no-brainer.” What I encouraged the client to consider is taking a slightly different vantage point by asking, what would cause me to regret making this decision?
So, ultimately, what’s the wisdom we glean from these types of exercises? We are reminded that the future is unknown, scenario planning is beneficial, and any situation with a handful of variables will leave us having to make our best-educated guess.
I get concerned because I see many planning ideas that were birthed from the advice of a Wall Street Journal article and never thought through whether they’d be suitable for that particular investor. Remember, it’s called “Personal Finance” because it’s personal, and all of your planning decisions should be customized to your situation, your preferences, and your personal aspirations.
Maybe a Roth conversion is appropriate for your financial plan, or maybe it isn’t. What we do know is that it is very fruitful to dialogue on these types of planning questions alongside whoever your financial guide is. So, as you surround yourself with turkey, gravy, and the financial opinions of your relatives, I hope you will slow down and calculate what plans are most appropriate for you.