Happy Holidays! This December we have a timely treat as we discuss what Roth Conversions are and attempt to provide an inside look at how to determine if it makes sense for you or not. Next month we will go back to talk about deciding between going with Roth or Traditional Contributions. For now, we thought it would be a prudent time to provide some education on Roth Conversions with a detailed case study, so buckle in!

First, what is a Roth Conversion? Well, you may have heard of it as a “Back Door Conversion” or some type of tax loophole, but we are going to stick with Roth Conversion for today. The simple definition is this; Take Traditional Contributions that are already in retirement accounts and convert them to a Roth IRA by paying the taxes from non-retirement assets. As a refresher, take a look at last month’s blog to understand the difference between the two.

Most of the time when this is brought up proactively to me by a client, the first thing I explain is how it works and what your out-of-pocket costs are. Well, as you know from our first blog, it depends on what your personal tax situation looks like. From a bird’s eye view, it means that the amount your convert is added to your ordinary income for that tax year and taxed at that marginal rate.

Why do people use an advisor? Well diving deeper, that means it can completely change and upend your existing tax plan if you don’t do some due diligence before deciding to do a Roth Conversion. If your Social Security is being taxed at the lower end of 50% of your benefits, it could move you to 85% being taxed. If you are already at 85%, you could be moved from the 12% tax bracket to the 22% bracket. And if that isn’t enough, you could hit IRMAA Tax Cliffs and pay higher premiums for your Medicare without even realizing it! We can tell you that people don’t like surprises that cost them money!

Hypothetical Example

Client (Age 55) currently has a Traditional IRA with $1,350,000 balance. The client’s salary is $225,000 and their spouse’s salary is $150,000. They file taxes Married Filing Jointly, with an Adjusted Gross Income of $350,000 which puts them in the 24% Marginal Tax Bracket for 2023.

  • How to look at this scenario? First, notice that the salaries of this couple are a total of $375,000 and the Adjusted Gross Income (AGI) is $350,000. Without going down a rabbit hole, they are two different numbers which a tax professional determines when they do your taxes.
      • On your tax return, you would find this on IRS Form 1040, Line 11.
  • A $350,000 AGI puts this couple in the 24% marginal tax bracket which is $190,751 – $364,201 in 2023. These numbers are annually adjusted for inflation by the IRS.

If this couple wanted to convert $150,000 from the Traditional IRA to a Roth IRA, there are a few things to think about:

    1. Will this benefit them in the long run? By putting money in the Traditional now, they are avoiding their current 24% tax bracket and will pay at whatever the income bracket they are in during retirement when they take distributions. This is LOADED QUESTION.
      • We don’t know what tax brackets will even be 20, 30, or 40 years from now.
      • Plans constantly change.
      • Laws constantly change.
      • The point here is that there is not a perfect black and white answer, because It Depends!
      • Answer – For this client, let’s say that they expect taxes to go back up (2017 Tax Cuts and Jobs Act) in future years, so they would at least expect to be in a similar tax bracket due to their retirement savings plan, but certainly not a lower bracket.
    1. What is the time horizon for the Roth Account? With a Roth IRA, you do not have to take a Required Minimum Distribution (RMD) so the time horizon can be longer than other accounts. With the client being 55, and assuming they plan to retire at 67 when they will have other assets to live off of such as Social Security, we can call this a 20-year time horizon.
      • That is 20 years of tax-free growth that will not be taxed again in the future.
    1. At this point, the client thinks this is a win-win situation because they are going to pay the same tax now on the amount that they convert, as they would if they take the same distribution in retirement. It can grow longer because they won’t have to take RMD’s from it, and that growth will not be taxed. (To that extent I would agree.)
    2. But we now must consider what they will have to pay today in taxes. The 24% tax bracket ends at $364,201 for a couple Married Filing Jointly. Which means they can convert $14,201 in the 24% bracket and then the rest of the $150,000 goal would actually be taxed in the 32% bracket!
      • $150,000 at 24% is $36,000 in tax that they would be paying out of regular savings.
      • With the 32% bracket coming in to play, the total changes to $46,863, a difference of over $10,000!

If that client came back in the spring, they would not be very happy campers. There are many ways to plan in advance to convert as much as possible at lower tax brackets, but it doesn’t happen overnight.

When we get a new client, especially before retirement and Social Security ages, we often plan for conversions by putting money in the right places years beforehand and utilize those conversions as a part of our Tax and Drawdown Strategy. This creates significant tax savings sometimes in the millions of dollars without even looking at investment performance. It is much easier to understand when your advisor has already done the detailed work and research for you, which is why ongoing Financial Planning, is incredibly valuable. A “one-time plan” is a stagnant document that simply cannot keep up.

If you are considering this for tax year 2023 and this made you pause, now may be the time to call. If you see the value that this can provide you as you plan for retirement, then don’t hesitate. The longer you wait to plan, the fewer options you will have.

About Forman Investment Services

If you are not familiar with us, Forman Investment Services is an independent practice located in Columbus, Indiana focusing on Family Wealth Management and generational planning. We serve clients not just locally, but across the country and globe. In today’s day and age, especially after experiencing COVID, we are very comfortable communicating from any distance whether it be in person, a Zoom call, or by phone. We confidently adapt to our clients lives and unique relationship in the style of communication and complexity.

Our planning encompasses much more than choosing investments, as we must consider tax/estate planning, education funding, insurance, retirement planning, and so much more. We work with a select group of clients who value time, family, and recreation, and need today’s investment, tax, and estate planning complexities coordinated for them. We also provide one-time plans to those that are not in need of an ongoing advisor relationship yet to help get you on the right track.

Reach out to us for an introduction if you are interested in learning more!

Any opinions are those of Forman Investment Services and not necessarily those of Raymond James. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Raymond James and its advisors do not offer tax or legal advice. You should discuss any tax or legal matters with the appropriate professional. Prior to making an investment decision, please consult with your financial advisor about your individual situation.

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Published On: December 15th, 2023Categories: Blog