This year, some of the most frequent conversations we’re having revolve around upcoming tax changes. In 2018, then President Trump lowered tax rates across the board. Ever since, we’ve known that it’s likely tax rates will never be lower than they are right now. Now, under the current administration, tax rates are being heavily discussed and we expect them to go up. By how much? That’s the magic question. Regardless, we’re incorporating the discussion of whether or not it makes sense to do a Roth conversion for certain clients before tax rates increase. So, what is a Roth conversion and what considerations should you make before completing one?

If you’ve ever contributed to your employer’s 401(k) or to a traditional IRA, you’ve gotten a deduction for making those contributions. Those contributions are what’s known as “pre-tax”. Meaning, you didn’t have to pay taxes on the money you put into that retirement account. Also, the money your employer matches into your 401(k) is considered pre-tax as well. This means that when you pull money out of your 401(k) or IRA when you’re retired, you’re going to be taxed at ordinary income tax rates on each and every dollar. What can be done to avoid paying taxes on this money when you’re retired?

Roth conversions. Now, before explaining the depth behind Roth conversions, know that this is very specific to an individual person’s exact situation and lots of care and thought should be had before doing one (consider discussing with your financial advisor or tax professional). A Roth conversion is the process of taking your pre-tax 401(k) or IRA money and converting it to Roth. This means paying taxes now on the entire balance of the money you convert.

Think about it… you’ve gotten a tax deduction on all that money you’ve put into your 401(k) or IRA. The IRS is perfectly okay with this because they know when you pull all that money out one day, they’re going to get their fair share of tax revenue from it. Not only is the IRS going to tax you on the money you put into the 401(k)/IRA, but they’re also going to tax you on all of the gain and growth its had over your lifetime. You can completely avoid this with a Roth conversion.

For round numbers, let’s say you have $100,000 in a traditional IRA. Maybe this was from an old job that you rolled over and the total amount includes some of your contributions, some employer match, as well as some market growth. If you let it grow during your working years once you retired, you withdrew the money to live off of, you’d end up paying taxes on every dollar you pull out. Now, if you chose to convert the entire $100,000 today, you’d pay taxes on the full balance, and never owe any more taxes on that money again. The IRS collects their tax revenue from you now, while you let the money continue to grow 100% tax-free until you retire. The IRS is only concern with collecting their tax revenue at some point, whether it’s now or later.

Before you do a Roth conversion, here are some of the biggest considerations:

  • You have to have the money to pay for the conversion outside of the IRA (cash on hand). In the above example, let’s say you end up owing $20,000 of taxes for converting the $100,000 IRA. In order to pay the taxes, you’ve to have that cash in addition to and outside of the IRA. This is a large chunk of money to be able to front for taxes on money you can’t touch until you’re 59 ½.
  • The money you convert could bump you up to a higher tax bracket. The entire balance is taxed at ordinary income tax rates. If you do a sizeable conversion, this could heavily increase your taxes.

So, when would be a good time to consider doing a Roth conversion?

  • If you’re income is extremely low one year and you expect it to go back up. Doing a conversion in a year when your income is low could enable you to take advantage of a lower marginal tax rate versus being taxed at the top tax rate during a year when your income is extremely high.
  • If/when the market has a temporary drawdown. We’re not market timers and don’t claim to be, but we frequently see dips in the market. If your $100,000 IRA falls to $80,000 and you’re confident it’s going to come back and grow, why not go ahead and convert it and only have to pay taxes on $80,000 versus $100,000?
  • If you expect your income tax rate to be higher than it is now when you’re retired. I discuss whether to contribute Roth or pre-tax in a recent blog post here. Pay taxes on your IRA now when your marginal tax rate is low rather than when you’re retired, and your tax rate is higher (if this can be known and predicted).

As can be seen from the above, there’s many considerations to be had for doing a Roth conversion. It shouldn’t be taken lightly and should have heavy amounts of consideration and advice. We value being able to provide this thought-out advice for clients because the outcome can be potentially life-changing with the amount of taxes that can be saved. We’re here to walk through any questions you may have!

Raymond James does not provide tax or legal services. Please discuss these matters with the appropriate professional.

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