With the upcoming tax deadline looming large, are you still interested in the subject of taxes? For those of you who just thought, “ugh,” I’ll rephrase that question; How many of you are interested in ways to save on your taxes? If you have already written a large check to Uncle Sam to accompany your latest tax return, you’ll most likely want to keep reading.
Investing in a Roth Conversion is one of my favorite tax savings strategies to speak with Osiwala Financial Group clients about. If you aren’t familiar with what a Roth Conversion does, it allows you to move money from a traditional IRA to Roth IRA. Granted, that’s a simplistic explanation, but that’s the basic process. So what’s the catch? Taxes on the amount of money moved into a Roth IRA are paid in the year that the move is made. So if a client decides to do a $20,000 conversion, you will pay taxes as though it was earned income in that tax year. By doing this, you can move money out of your traditional IRA to lower your required minimum distributions at age 72.
Another reason to complete a Roth Conversion (and one that people don’t typically think about) is: What would happen if a spouse passed away prematurely? Some couples are lucky enough to live to a ripe old age. But that doesn’t always happen. And when a spouse dies, the other partner may also lose a pension or a Social Security benefit that ordinarily helps them to pay their monthly living expenses. However, those RMDs out of Traditional IRAs that have never been taxed never get smaller even though the living spouse is now a single tax filer, creating new financial stress. A Roth Conversion can help to protect the remaining spouse by minimizing the taxes they’ll have to pay later in life.
Another reason that a Roth Conversion may be advantageous is for legacy purposes. With the passage of the Secure Act, if someone inherits an IRA, those funds must be 100% distributed out over ten years, and you must pay taxes on them. With a Roth IRA, your loved ones who inherit it don’t pay taxes on the distributions they take from that account.
As certified financial planners, one of the things we do is calculate the amount of tax savings over a time period. Depending on the size of the account, we may see upwards of $100,000 or more of tax savings over a ten-year time frame. When it’s that amount of money, I believe it’s a conversation worth having. But many others will benefit, too. Interested in having this conversation? Click HERE to schedule.
A while ago, I had a meeting with a prospective client. As we were getting to know each other, he told me that he had been doing Roth Conversions because he “wanted to do everything right.” I told him that he was off to a great start. And then I inquired about how the Roth Conversions fit into his overall retirement plan. He shrugged his shoulders and said he converted approximately $30,000 a year.
While, on the surface, his plan sounds great, Roth Conversions are not something you want to shoot from the hip on. There’s more that goes into them. You have to consider things like: What is your effective rate for conversions, and what is the actual cost?
Another issue to think about is Medicare Part B premiums. That’s an additional tax that comes from higher income levels that can be very punitive for people on Medicare. Understanding how to control distributions while keeping them tax-free will positively impact Medicare premiums. While it’s critical to remember that Roth Conversions offer great opportunities, it’s also essential to understand the tax ramifications that you may be creating as a consequence of using them.
If we go back to the basics of 401(k) planning, the initial intention was to allow people to take their retirement into their own hands. Corporations were tired of paying pensions and having the responsibility of making pension payments for that person’s life. The 401(k) allowed financial advisors to go into the companies, take some of that pressure off the corporation, and put it back on the employee.
How do you know if you should move forward with a Roth Conversion? You have to have a financial plan that’s overlaid with a tax plan, so that we can see what tax bracket you are currently in. Then we can discover what tax bracket you will be in 5,10, and 15 years from now. And it usually makes sense to prepay some of that tax. But, sometimes it doesn’t. That’s where you want to look forward and discover what your situation will be. I’m not saying this is a strategy everyone should be targeting. Roth Conversions should be completed on a case-by-case basis.
Another critical point is the fact that you can control this tax outcome while you’re still employed. Almost every 401(k) in America has a “Roth option.” But how do you know if you should take advantage of a Roth IRA while working or contribute to a Traditional IRA? It would be best to look at your tax bracket every year. Theoretically, if you’re a young person entering the workforce in a low tax bracket, go ahead and make the 401(k) after-tax contribution. But the instant that your tax bracket goes higher because of increases in salary or bonuses, you need to go back and revisit it. At that point, you may decide that making the after-tax contribution may not make sense anymore.
Roth IRAs are an excellent benefit, yet too many people don’t understand their ultimate future reward. If you’re entering the workforce, think about all of the time you will have over your career where that money grows tax-free. Want to learn more about Roth IRAs or Roth Conversions? Schedule your free, no-obligation conversation with an Osiwala Financial Group Advisor. We can do it by phone, in-office, or virtually. All you have to do is click HERE. Not ready to talk to us just yet? Go to our Education Center and download your copy of our “Retirement Plan Checklist” by clicking HERE.