Clients may think once they hit retirement, let’s call it age 65, that their planning becomes less complex. Their accounts may have been consolidated, they may have come to a decision on when to take social security and their pensions, and their estate planning is up to date. However, sitting idle during these early retirement years tends to be a mistake. The years between a client’s retirement to their required minimum distributions from their tax deferred accounts is one of my favorite planning timelines.
During this timeline, their income tax rates may have been reduced from higher tax brackets down to lower tax brackets since they are no longer earning a salary. Dividends and capital gains rates are likely lower than their earned income as well as social security only being taxed on 85% of the benefit. With all of these items going to their favor, it may be the perfect time to look at doing Roth conversions on any tax-deferred assets such as Traditional/SEP/SIMPLE IRAs and their employer retirement plans.
A Roth conversion is converting tax-deferred assets to tax-free assets. This conversion entails you paying tax on the converted amount. Here are some questions I have received in the past that I would like to clarify.
Clarification #1: You can only convert the amount of the IRA contribution for that year.
Answer: False
You can convert your account from Traditional to Roth at any time for any amount. From a time value of money perspective, the tax authorities are getting your money now rather than later. In return, you are receiving tax-free growth on your earnings by locking in that tax rate.
Clarification #2: You cannot convert employer sponsored retirement plans from Traditional to Roth.
Answer: Maybe
If the plan document stipulates that you can do in-plan conversions and have a Roth option, you shouldn’t have any issues. If the plan doesn’t have that feature nor a Roth option, you cannot perform this strategy. The good news is you can always roll your retirement plan into an IRA at a qualified custodian and do it through them. Just make sure this doesn’t impede other planning.
Clarification #3: I should pay taxes with the money I am converting.
Answer: Maybe
I generally do not like to have my clients use the funds they convert to pay the taxes if possible. They would be paying taxes with funds that would have grown tax-free. The downside is they would have to come out of pocket to make the payment through an estimated tax payment to the IRS and state taxing authority (if applicable). Therefore, I would recommend just making an estimated tax payment rather than using the funds in your account to cover the taxes owed.
Another reason why I believe the Roth conversion during this timeline is a great strategy is just the general nature of Traditional IRA withdrawals. Anytime you need cash from one of the accounts, you will not only need to take the money out to cover the expense but will also need to take out the taxes. So the formula would actually be Money Needed/(1-Your Federal Tax Rate – Your State Tax Rate). In my experience, it tends to be a vicious circle and you must constantly increase the amount you need to take out to cover the tax ramifications.
Just wanted to give everyone some food for thought regarding Roth conversions and this strategy to lock in tax rates of your choosing, not someone else’s!
Happy to chat if you have any questions.
Michael Sherman, CPA, CFP®, CPFA, CDFA®
OWNER
Sherman Wealth Solutions LLC
Michael.Sherman@shermanws.com
O 980.350.0170
F 980.350.0180
www.shermanws.com
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