Should I Convert My IRA to a Roth?

I hear that question often during my initial meetings with clients.

What would a conversion do for me?

How would that hurt my savings?

To answer any of those questions, we have to begin by reviewing the direction that that tax law is moving today.

As many of you know, there was a stir in the news this past month because Alexandria Ocasio-Cortez, a congress woman, attended the Met Gala– a ritzy event with only about 400 elite attendees per year– and wore a dress emblazoned with the words: “Tax the Rich.”

A congress woman took it upon herself to accept a $35,000 ticket, then wore a dress like that. This is a great example of the current tone of our government and the attitudes of some of our elected representatives. I'm not trying to make a political statement here, I'm merely pointing out that this current tone certainly points to taxes going up rather than coming down in the coming years.

Another vital piece of information that many don't realize is:

If you make over $84,000 a year, you’re considered by America to be among the top 25% of all wage earners. That places you in the group that already pays 86% of all income tax to the United States government.

Does being in the top 25% make you a tax target of the "tax the rich" mentality?

Most likely, to some extent.

Now that the public debt is rounding the corner to 29 trillion dollars (when it was around 26.5 trillion in July of 2020), we are watching a bipartisan sparring match in congress as fingers are pointed and different tax hikes are being proposed frequently. Yes, we have people on the right proposing to cut funding and people on the left proposing to raise taxes– what will most likely come out of this will be a compromise where both of those things end up happening simultaneously to some extent.

It’s an inescapable fact that the US added nearly 2 trillion dollars to the national debt over the course of one year (summer 2020 to summer 2021) and that means people are starting to really question whether deferring their taxes will be beneficial in the long-term.

Wait, the question was about a Roth conversion, why all the tax information?

Because, with a Traditional IRA, you can get a tax break this year by putting pre-tax dollars into the IRA now, and waiting to pay taxes on that money until you withdraw it sometime in the future.

With a Roth IRA, you pay taxes on the money this year, but when you take it out, it’s tax-free.

Many people have invested in Traditional IRA’s because they were able to get a tax break in the current year and also save something for retirement. Often, these investors believe that they will have a smaller overall income in retirement, therefore they’ll be in a lower tax bracket.

Sometimes this is true, sometimes it isn’t.

There are often situations that are not considered when looking toward the future. For example, you’ll have less deductions than you do now. If you have children, they won't be on your taxes anymore and your mortgage could be paid off... there are a number of factors that can cause you to have less deductions and therefore end up with a higher tax bill in the future.

Also, you need to look into what your Required Minimum Distribution will be for your Traditional IRA accounts.

Some find that when they add up all of their retirement income streams, their RMD will be more than they actually need in their budget. If that’s going to be the case for you, it’s important to figure that out early on and take steps to address it. You’d be better off rolling over a portion of your Tradition IRA into a Roth than taking the full RMD and paying taxes on it when you don’t really need it.

Most importantly, conditions are ripe for Roth conversions if you start it now, before 2021 ends.

But what does that mean?

For conditions to be ripe, there have to be two factors at play:

LOW taxes NOW and the promise of HIGHER taxes LATER.

As Jamie Letcher from Kiplinger reminds us, “the tax reform passed by Congress in 2017 reduced marginal tax brackets, but included a sunset clause that would revert brackets to 2017 levels in 2026 in the absence of action by Congress. If that happens, people now in the 12% bracket will revert back to the 15% bracket, and those in the 22% to the 25%, and so forth. Relative to history, we are in a low tax environment today.”

The tax brackets we are living under today are probably the lowest we will see. There’s chatter in congress about raising taxes and it doesn’t look like we’re getting out of 2022 without some action being taken on this front.

If you have the ability to do a conversion, and if it works for your personal situation, now is the time.

However, there are some cautions to keep in mind before you take that step:

When you roll your traditional IRA over into a Roth, it actually counts as income for the current year.

If you decide that “yes, the time is right for me to roll this traditional IRA into a Roth,” you really have to look over your personal finances this year to make sure you can do that. Let’s say you decide to roll over $20,000 of Traditional IRA money into a Roth IRA tomorrow, that $20,000 will be added to your Adjusted Gross Income on your tax return for this year.

This move could put you in a higher tax bracket this year. However, you have to remember that it could also keep you from an even higher tax bracket later and you wouldn’t ever have an Required Minimum Distribution on that money because RMDs are only for Traditional IRAs.

It’s also vitally important that you have enough money in your current savings accounts to cover the extra taxes that the $20,000 will bring this year.

It’s strongly advised that you don’t use IRA money to cover the tax bill for a rollover because you’d be adding more to your tax bill by withdrawing more from the IRA to pay the tax bill.

In summary, before you take the step to pursue the rollover, you need to:

  1. Have an idea of what you estimate your current income is and what your tax burden looks like for this year.

  2. Have a projection of what your Required Minimum Distributions will be on your current IRAs so that you know what your income will look like in the future. This will give you an estimate of what taxes you may have to pay in the future.

  3. Understand how an increase in the tax bracket could affect that tax you’ll be required to pay in the future.

Once you have these three pieces of information figured out, you’ll be able to see if moving forward with a Roth conversion would be to your benefit. Remember, the benefits to a Roth rollover would be that you’ll never have to worry about taxes going up because you’ll have secured a tax-free savings and you’ll be free from dealing with the RMDs in the future.

However, if you don’t have the savings to pay the taxes on the rollover today, it probably isn’t the best idea for you to move forward.

If you need help with any of these projections and calculations, remember, we are always here to help you make the best choice for your unique situation.

I’m here for you if you get stuck or confused, just shoot me an email or give me a call.

You’re not alone in this planning process.

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