Director of Financial Planning at Blue Rock Dravo Bay. I’m strongly committed to the financial planning industry. I take great pride in empowering clients and becoming their financial confidant.
As we write this article in the midst of the global Coronavirus pandemic, most of the world is sheltering in place at home. While the long term economic impacts of the pandemic are unknown, our fundamental approach to wealth management has not changed. Rest assured that while you are taking care of your family and your health, we’re focused on ensuring your retirement assets are working for you in the best way possible. Now more than ever, we are reminded to focus on what is within our control. While some of our clients are advised to make no specific changes to their retirement strategy at this time, a Roth IRA conversion may serve some of our clients in 2020 and/or in future years. This article will highlight IRA basics and some of the questions to consider in your Roth IRA conversion decision-making process.
Individual Retirement Account (IRA) Basics
Individual Retirement Accounts (IRAs) were created in 1975 for working Americans who would not receive a retirement pension from their employer. An IRA is an account you open at a brokerage or bank. That institution holds your IRA assets, which is made up of your choice of mutual funds, stocks, bonds, money market funds or exchange-traded funds. The particular “mix” of investments you choose for your IRA largely depends on your age and tolerance for risk. If you’re in your 50’s or older and were not contributing to a pension or 401(k) early in your career, you may have started off with a Traditional IRA, until the Roth IRA was established as part of the Taxpayer Relief Act of 1997. The Traditional IRA allowed taxpayers to invest a portion of their salaries to grow tax-free until retirement. The primary benefit of the Traditional IRA was a tax deduction in each year you contributed to your IRA. In short, you ‘kicked the tax can down the road’ until retirement when Uncle Sam would collect his due. The Roth IRA gave investors the option to pay taxes on their income upfront. The appeal of withdrawing retirement funds without worrying about taxes has led millions of Americans to choose the Roth IRA.
Is a Roth Conversion a Good Idea For Me?
A Roth IRA conversion is the process of converting part or all of your Traditional IRA assets into Roth IRA assets. Essentially, you pay taxes now instead of tomorrow. Sounds like a good idea, right? Maybe. It all depends on your unique financial situation. A major player in that decision is your tax situation. Believe it or not, but the timing of a Roth conversion should take your tax bracket into consideration. It is important to analyze which tax bracket you are in now and where you expect to be in the future. This can help determine when a conversion makes the most sense for you from a tax perspective. Since many people hit their peak earning years right before retirement, Roth conversions early on in your career tend to be an attractive option. Roth conversions also make sense for people who are experiencing a low-income year, whether from leaving a job or taking an extended vacation or even accepting a new position with a lower salary. The less taxable income you have to report, the more lucrative a Roth conversion could be for you that year. With a Roth conversion, is important to be proactive about your tax strategy. By timing a conversion correctly, you are able to pay taxes at a lower rate and withdraw the money tax-free when you are in a higher tax bracket. Our team is mindful of the many factors that can make a Roth conversion valuable for you. 2020 has been a year of many changes some of which could impact your ability to make a Roth conversion. The new economic stimulus package, the CARES Act, has provided many benefits as we all navigate our way through the changes caused by the Coronavirus. One provision is the suspension of RMDs (required minimum distributions) for 2020. This not only impacts those who are already taking RMDs but also those who just turned 72 and would need to start. Remember, RMDs are seen by the IRS as income, which therefore increases your taxable income for the year. By not having to add this added income to your balance sheet, you may lower your taxable income to a point where a Roth conversion could make sense for you. Even the most finance-savvy can feel overwhelmed trying to decipher the pros and cons of IRA conversions. We highly recommend a conversation with your financial advisor team before you make a final decision.
Tax Consequences of Roth Conversions
Because you pay taxes on the amount converted during the year of conversion, the biggest consideration for most people is whether they’re able and willing to pay taxes on the total amount converted. For example, let’s assume you’re in the 24% tax bracket and convert $20,000 in 2020. Your taxable income for the 2020 tax year will increase by $20,000. If you convert $40,000, add that amount to your taxable income. You’re looking at several thousands of dollars in either scenario. While you can pay the conversion taxes next April with your remaining IRA assets, we don’t recommend it, and investors under age 59.5 may pay a 10% penalty to do so. It pays to think things through months in advance before your tax bill comes due. If for any reason you land in a lower tax bracket in 2020 due to the Coronavirus or other life event, a Roth conversion may make 2020 a good year to convert all or part of your Traditional IRA. If you do opt for a Roth conversion, an important reminder is to set aside the cash reserves you’ll need to have on hand when next April rolls around. We wouldn’t want you to have to pull funds from undesirable accounts at tax time. Many people find it more palatable to convert a certain amount yearly for a few years. As part of our pros and cons discussion, we’ll run the numbers for you so you can look at tax liabilities of a partial vs. entire conversion. The scenarios above are just a few of the many that will impact your portfolio and your legacy.
Questions to Discuss With Your Financial Advisor
Simply speaking, your options are 1) convert some, 2) convert all, or 3) convert none. Here are common questions to discuss with your advisor: What is my age today? What is my income today and what is it likely to be when I retire? Will my tax bracket be higher in retirement, or lower? Do I have enough cash reserves now to pay the conversion taxes?What’s the “payback time” in years I’ll survive in retirement to make that upfront payment worth it? How many years from today until I will start to draw on my Roth assets? If I keep my funds in my traditional IRA and am required to take my RMDs, what will the impact on my portfolio growth be? Does my estate trust direct my IRA assets to my heirs upon my death? How Blue Rock can help
As you can see, these decisions can be interlocking and interdependent and require scenario planning and fact-checking. As proactive tax planners, we’re keenly focused on future income projections, tax liabilities, and how to extend the life of your retirement portfolio. We look forward to guiding you to the decision that’s best for you and your family. Call your Blue Rock advisor today, or if we haven’t met you yet, schedule a conversation with us today or call us at 302-660-3350.