If you are in or approaching retirement, you have probably heard about Roth conversions.
A Roth conversion is the process of moving funds from a pre-tax retirement account, like a traditional IRA or 401(k), into a Roth IRA. This move requires paying income tax on the converted amount in the year of the conversion, but the money can then grow and be withdrawn tax-free in the future. When used effectively, a Roth conversion strategy can reduce the lifetime tax bill for you and your heirs.
But, as with any tax strategy, the devil is in the details, and under the new tax laws, there are a lot of details.
For example, here is a sample client tax situation.
This couple is squarely in the 12% tax bracket, and they can convert $20,000 of IRA money to a Roth without exceeding the 12% marginal tax bracket. They think their tax bill will be higher in future years (once required distributions kick in), so a Roth conversion seems like a good idea.
Except the tax bill for a $20,000 conversion isn’t $2,400, as they might expect (12% of $20,000). Instead, in this case, the conversion would create an additional tax bill of $6,025, effectively a tax rate of over 30%.
How did this happen?
Making the Roth conversion would change the tax rate on their capital gains and begin phasing out the new Enhanced Senior Deduction for those over 65.
In another case, I was speaking with a client who was thinking about converting $20,000 because “it was the same amount we converted last year.”
However, doing so would take their tax bill from $2,575 to $10,759—an effective tax rate of over 40% on the conversion.
The steep rise was the result of the conversion’s impact on the taxation of their Social Security benefits, capital gains, the phaseout of the Enhanced Senior Deduction, and a step-up in their marginal tax bracket.
This isn’t to say Roth conversions are bad. They can be a tremendous planning tool when used effectively. However, Roth conversions require tax planning, and tax planning requires analysis.
So please, before doing a Roth conversion (or really doing anything tax-related), run the numbers. If you need help, send us a copy of your previous tax return, and we’ll be happy to coordinate strategies with your tax person.
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