How Do You Actually Make a Roth Conversion?
Everyone is always talking about Roth conversions. As we have seen more and more government spending, and as balances in tax deferred accounts like Traditional IRA's and 401(k)'s grow and grow more people are looking for alternatives to manage their future taxation. A Roth IRA conversion is one of those alternatives, but what exactly is a Roth conversion, and more importantly - how do you do it?
Today's Retirement History Lesson
Planning for retirement has changed substantially over the past 50-60 years. Once upon a time people expected to go to work at a company, often right out of high school, and work at that company their entire career. In exchange for that work, they earned a living and also participated in a company pension plan. Those plans were designed to provide a certain amount of income each month for the rest of the employee's life once they retired. Combine that pension with Social Security, and some savings in a bank and you were pretty well set. Since those days everything has changed - cash in the bank earns little to no interest nowadays, and companies typically do not offer pensions any longer. Many began to switch back in the 1980's to "Defined Contribution" plans like a 401(k). This is a plan where the employee is required to save for their own retirement and the company may add some money via a company match or a profit sharing component. What happened with this switch was that the company transferred longevity risk (the risk that you live a long time in retirement) from themselves to you. They would no longer need to be concerned with making a monthly payment to you from the pension fund every month. Once folks understood this many began funding their retirement in earnest by maximizing their 401(k) contributions. That's a great thing, but it comes with a drawback. Money put into an account like that goes in pre-tax and grows tax deferred but that means that taxes are due when it is withdrawn from the account. After years of savings and growth many people have the vast majority of their wealth tied up in money that is yet to be taxed.
The Tax Man Cometh
As they old saying goes - nothing is certain but death and taxes. As retirement planning changed, and tax deferred balances grew and grew one thing became certain - many folks were looking at major tax bills in retirement as they started to access the money they put away. That brought about the creation of the Roth IRA - this is an account that is funded with post-tax money. As a result, money that goes into a Roth goes in after it has been taxed, but then grows tax deferred and can be used in retirement tax free! Think of it as the yin to the Traditional IRA/401(k)'s yang. It is the opposite in that you pay the tax upfront instead of at the end. The benefits here are several - 1) You don't have a large future tax bill hanging over your head to access your own savings. 2) It can create flexibility in where you draw your retirement income and how. Having a pool of money that does not need to be taxed gives you options when you start distributing your assets to meet your living expenses in retirement.
Conversion Vs. Contribution
The primary drawback to Roth IRA's is that they have relatively low contribution limits. In 2021 the most you can put into a Roth IRA is $6,000. If you are over the age of 50 you can add an additional $1,000 for a total of $7,000. That's nice, but it might not make a dent in your future retirement needs. The alternative to contributions (putting new money in) is a conversion (moving existing retirement funds into a Roth). The rules on conversions have become more and more relaxed over the years and at this point almost anyone can convert existing Traditional IRA money into a Roth IRA as long as you pay the tax that is due. That's the rub, to convert from pre-tax to post-tax means you need to pay the tax today on money that you are converting. That can certainly still be beneficial, especially if you have a number of years to benefit from tax free growth after the conversion. So that brings us to the question of the hour - HOW do you actually convert from Traditional IRA money to a Roth?
Fill Up Those Brackets!
One popular strategy is called "Filling Up The Bracket". Our tax brackets are progressive, meaning the more you make, the higher the percentage of that income you have to pay in taxes. A key Roth conversion strategy is to convert everything you can to take you to the limit of the your current bracket without pushing over into a higher bracket. Thus "filling up" the bracket. As an example - in 2021 the 24% federal tax bracket for a married couple filing jointly caps out at $329,850. That means you can have $329,850 of federally taxable income before you would push over to paying 32% tax which would begin on the next dollar. So let's say as an example you are married filing jointly and you have $180,000 in taxable income and that you have substantial money in Traditional IRA's. You would have the ability to convert over $149,850 from Traditional to Roth this year, without pushing into a higher tax bracket. That could be a valuable strategy to employ, not just in the current year but in future years until you have converted enough to feel comfortable with your asset mix in retirement.
Get In Touch:
If you have questions about converting funds to a Roth IRA, whether utilizing the Filling Up the Bracket strategy or looking at other options, feel free to get in touch. As you know we love talking about this stuff, and we'd be happy to talk to you about your situation as well. Give us a ring, or drop a line and we'll be happy to help: