Complex Conversion Calculations

tax returnsChances are, you know about Roth IRAs and what makes them special.  Any contributions you make are taxable, and if you convert all or part of a traditional IRA to a Roth, you have to pay taxes at your ordinary income tax rate.   But (the special part) you can take retirement distributions or income from the Roth tax-free, no matter what tax rates do in the future.

You’ve probably also seen calculators which purport to tell you whether it makes sense to convert traditional IRA monies into Roth dollars.  The calculators compare the taxes you have to pay now for the conversion versus the taxes you save in the future on withdrawals.  The normal conclusion: if you expect your marginal tax rate to be the same or lower in retirement than it is today, the conversion doesn’t make sense.

The problem with these analyses is that in many cases THEY don’t make sense.  Why?  First of all, because your marginal tax rate is only a part of the story.  A taxpayer in the 39.6% marginal bracket isn’t really in the 39.6% bracket because he or she is also subject to the 3.8% Medicare surtax, plus the phaseout of itemized deductions plus a higher capital gains rate.  So if the analysis is assuming a 39.6% rate in the future, chances are it is understating the actual rate by ten percentage points or more.

The second problem with these analyses is that they ignore the flexibility you get when a portion of your retirement money becomes available tax-free.  The advice you read online says that in retirement, you should spend down your taxable portfolio and let your traditional and Roth IRA accounts grow tax-deferred.  If you don’t have a Roth, then your traditional IRA continues to grow until the taxable account runs out.

Then what?  When you reach age 70 1/2, you have to start taking mandatory distributions from your traditional IRA, and the size of your required distributions goes up in each subsequent year.  For many people who have done everything right–saved carefully for retirement and loaded up on the tax-deferred IRA–those distributions could easily throw them into the highest marginal bracket by their mid-70s, causing them to lose itemized deductions, get hit with the Medicare surtax and pay high taxes on their Social Security benefits to boot.  You can almost see Uncle Sam licking his chops.

But if some of your money is set aside in a Roth account, suddenly you have options.  In each retirement year, you can take money out of the traditional IRA up to a certain tax rate–say 15% or 25%, long before the surtax kicks in, before the deductions are lost–and then, if you need more income, take the rest out of the Roth.  Your Roth monies never show up on your tax return.  This gives you total control of your tax rate each year.  If Congress decides to add a bunch of other stealth taxes or raise marginal rates, you can basically decide how much of those taxes you want to pay.

And if you start taking money out of the traditional IRA early in retirement, at these lower rates, it reduces the mandatory distributions later–and the taxes that will be collected on them.

The point here is that determining whether or not to convert some of your IRA into Roth dollars is more complicated than the naive online calculators would have you believe.  It clearly doesn’t make sense to make a conversion if it will bump you up from a 25% rate to 39.6% on this year’s tax return, and trigger a bunch of of stealth taxes.  But somebody in the 25% bracket could make a partial Roth conversion that would use up the rest of the 25% bracket, and perhaps even bump up to the very top of the 28% rate with a somewhat larger conversion–taking advantage of the lower rate while still keeping income under the various stealth tax thresholds.

Similarly, if you have fluctuating income, then a year when your income is low represents an opportunity to make a significant Roth conversion, so you don’t waste that lower bracket.  You can skip the conversion during years when your income returns to normal (higher) levels.

Yes, these calculations tend to be complicated, but isn’t that what professionals are for?  If you’re interested in exploring your options, and perhaps protecting yourself from a tax nightmare in retirement, please let us know at your convenience.

 

 

 

About Objectively Speaking

Tom Batterman, founder of Vigil Trust & Financial Advocacy and Financial Fiduciaries, LLC is in the business of representing the best financial interests of his clients. Having provided objective, fee-only financial management services for over two decades, he specializes in managing the investment and related financial affairs of individuals and mutual insurance companies who do not have the time, interest or expertise to manage such matters on their own. As an objective, unbiased professional who takes on a fiduciary responsibility to his clients, he guides clients to the financial decisions they would make themselves if they had years of training and experience and the time and expertise to fully research and understand all of their options. Founded in 2010 as an outgrowth of Vigil Trust & Financial Advocacy, Financial Fiduciaries, LLC is a financial management solution for individuals and mutual insurance companies who recognize they do not have the time, interest or expertise to properly attend to their financial matters on their own. While there are many financial “advisors”, most of them have investment products to sell and the “advice” they provide is geared toward getting their clients to engage in a purchase. As one of the rare subset of advisors known as “fiduciary advisors”, Financial Fiduciaries does not sell any investment product so its guidance is not compromised by conflicts of interest which plague ordinary advisors. Prior to his employment in the financial industry in financial advocacy and trust positions, he worked at a private law practice in the Wausau area in the areas of estate planning, tax, retirement planning, corporate organizations and real estate. He is a graduate of the University of Wisconsin-Madison and the UW-Madison Law School and has during his career held Series 7, 24 and 65 securities licenses. A longtime resident of the Wausau, Wisconsin Area, Tom is active in the community. He enjoys golf, curling, skiing, fishing, traveling and spending time with his family.
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