Season of Roth Conversion
Very few instances exist when you can earn income or have growth of an asset while having no tax liability. A Roth IRA is one of those rare tools. You contribute after-tax dollars to a Roth IRA and the funds grow, tax-deferred. The longer the funds are left in the account to grow, the more the growth, and the higher the tax savings.* However, there are currently strict income limitations on who can contribute to a Roth IRA. In 2021 individuals making over $144,000 and couples making over $214,000 are ineligible to contribute to a Roth IRA. No such limitations apply to Roth conversions. Let’s take a look at how this might be applied.
One of the most basic concepts in tax efficiency is to smooth out income over multiple years. If income is particularly high in one year, there are a variety of techniques to reduce income to help smooth out the income curve over time. Roth IRA conversions can be used inexpensively in the years when your taxable income is low. In a Roth Conversion, part or all of a traditional IRA is converted to a Roth IRA and tax is owed as ordinary income. While this increases the taxes owed in a given year, it allows large sums to be placed in a Roth to grow over time.
A common situation is for clients who retire in their early 60s or earlier. Their income is high while they are working but drops significantly in the first years of retirement. They may not collect Social Security right away and they will not have RMDs from their traditional retirement accounts until age 72. Once RMDs start, their income will increase again. These interim years of low income may be the perfect time to do annual Roth conversions. The marginal tax rate may be extremely low, and the tax bill generated may be worth the future tax savings.
Another important note is that Roth Conversions must be completed by December 31st to apply to the current tax year. We recommend getting the process started by November so that there is time to properly plan and execute the strategy.
If you are interested in exploring a Roth conversion or want to discuss your specific situation, please reach out.
* To qualify for tax-free withdrawals, Roth IRA distributions must meet a five-year holding requirement and occur after age 59 ½.
Dillon Hakes, CFP
Lead Portfolio Manager
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