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Roth Conversion Basics

Roth Conversion Basics

In today’s blog, we will be presenting you with the basic overview of what a Roth Conversion is, how it can benefit you, why you should or should not consider one, and much more. Additionally, we will be answering common areas of confusion such as: When is it the right time to do a Roth conversion? How much should be converted? How do I pay the taxes that get generated from doing this process? And how do I avoid stealthy taxes that can cause more unwanted tax or Medicare premium payments? Keep reading to find out if Roth conversion is the next big step in your successful investment journey.

What is a Roth Conversion?

-A Roth Conversion is simply when you transfer money that you already have saved in a pre-tax retirement account and reposition them to a “Roth bucket” which is essentially a Roth IRA or Roth 401k. That pre-tax retirement account could be in the form of an IRA, 401k,  403b, or 457 deferred-compensation retirement plan. 

For an overview, Roth is an after-tax account, meaning taxes are paid before the money goes in and from that point forward, will grow tax-free. Under the current law, conversions can happen at any time. There are no age limits, no income requirements, and no cap on how much you can convert. For example, if you had a half-million dollars invested into your 401k and decide to convert all at once, you could do that! Though, you might be surprised by the tax bill. Whenever you take money off of your pre-tax accounts, it triggers taxes. So yes, when you move it over, you will get taxed at your ordinary income rates. Consequently, if you take out too much money, you could potentially bump yourself up into a higher tax bracket. This is why it’s extremely important to analyze where you are tax-wise before making this transaction. The most effective way to completely avoid this mistake is by contacting a financial advisor or CPA, such as myself.

Why Should I Consider a Roth Conversion?

Many people have a hard time understanding why they would convert to a Roth IRA and if it's worth paying the taxes now. After all who wants to pay the IRS sooner than they have to? 

-The real reason to convert now is that your pre-tax accounts are a growing tax liability for you! Many people consider themselves “debt-free”, but they don't understand that their 401k or their plan three accounts still has an IRS tax liability on them. For example, if you have a million dollars sitting in an account, the IRS is not taking their cut yet. If you're in the bracket of 25%, you actually only have $750,000. The $250,000 of that is still the IRS’s money.

So, essentially you still owe them a mortgage! What's worse is that the interest rate you owe them will vary depending on if taxes change. Increased taxes will actually decrease the amount of 401k you own. This is why one of the main benefits of doing the Roth conversion is that we're able to pay the debt that we know at today's rates. We know what the rates are today. We don't know what they’ll be in the future. If you think taxes may be higher in the future for you, then a conversion today would make a lot of sense! Remember, there are no conversion limits and no income restrictions, therefore, you can transfer as much or as little as you want to. 

This tax strategy is a Long-Term Play, meaning many people and their CPAs look at a three-year basis to examine what happened last year, what's happening this year, and what they can do next year to pay less in taxes. However, there’s a better way to get ahead of the IRS and pay less in taxes. The best strategy is to go Long-term and examine a 10 to 20-year time horizon. If you can plan out according to that, you stand a much better chance of winning when it comes to paying less in taxes. Overall, a Roth conversion is gonna take some time for you to acquire the benefits of it, such as the 100% tax-free growth once the money is converted into the Roth. 

Leaving your Money to your Children

-Now, the other reason to consider a Roth conversion is if you plan on leaving this money with your children. Under the current tax law of 2021, the stretch IRA is essentially gone. Any person that's a non-spouse that inherits assets on a pre-tax basis has to take the distribution within 10 years. If you have kids who you are going to pass the recovered assets onto, this is probably one of the worst things you can do, strictly from a tax standpoint. If you think about it, when most kids inherit their parent’s wealth, they're in their fifties or sixties and they're in their peak earning years, which means they're also in their highest tax bracket. If all of sudden they get a half-million-dollar inheritance and have to pull $50,000 per year, it's going to kill them in taxes. The IRS is going to make a lot of money on that. However, if your child inherits a Roth account, they can get that money completely tax-free! There is no requirement to make tax payments because you've already paid those taxes for them. 

When would a Roth Conversion NOT make sense?

-Leaving your money to a Charity Organization

If you want to leave the money behind to some kind of charity organization, that organization would typically inherit that money without owing any taxes to the IRS because they're nonprofit. There's no reason for you to pay the IRS if you're just gonna donate the money to charity anyway. As a result, you will not only pay more in taxes, but that charity organization is going to receive a lot less from you. That's one reason why a Roth conversion wouldn't make sense. 

-You think taxes are going to go down

The second reason is if you think your taxes are going to decrease. For example, say you are working and in the 28-32% bracket but predict in the future that you’re going to be in the 12- 25% bracket. In that case, it makes sense to not pursue a Roth conversion today. However, this doesn’t mean that Roth conversions are completely off the table now. This option is an annual tax review that should be revisited every single year to see if it makes sense or not for your situation. 

How Much Should I Convert?

-Remember, we're pursuing a Roth conversion, which is a taxable event, meaning if we convert too much, we're jumping brackets, that may or may not be the best-case scenario. The easiest way to know how much to convert is to visit last year's tax return, the current tax year, and see what bracket you're looking to be in. Once you accomplish this, then you will be able to recognize how much room you have before you jump brackets and set goals. If the goal is to go from the 12% to the 22% bracket, you can fill the focusing bracket to make the most use of it. Now, if you do go over, it's not the end of the world because we have a Marginal Tax System. Meaning, if we are off on our year estimate and you do dip into the 22% bracket by a thousand dollars, only that thousand dollars will be taxed at 22%. The rest got taxed at the 12% level. While you want to make your estimates as close as possible, if you are off by a little bit, again it's simply not the end of the world. A 22% tax bracket may be a bargain depending on what your future tax liability is looking to be.

When Should I Convert?

-Now, as far as when you should convert into the Roth IRA, you want to convert when taxes are in your favor! Do you find yourself in a lower taxable situation? Then great! Usually the earlier you do it the better. If you are in your sixties or seventies, a Roth conversion can still make sense in some cases. However, I’d advise you to obtain a professional’s opinion before furthering any plans. 

What time of year?

-Typically, the best time of year to convert to a Roth IRA is towards the end of the year because you have a more accurate estimate regarding your income for that year. This is why doing a Roth conversion during January or February is not advisable because if you end up making more money or inheriting money or something else happens, you will completely throw off your taxes for that year. Remember, Roth conversions are irrevocable meaning once you pull the trigger on this, there is no going back. You will be stuck with that tax bill that you just generated for yourself!

 How do I pay that tax bill?

-Remember that what you pay is based on your ordinary tax rates, so if you're in the 25% tax bracket and you move one-thousand dollars over, that's $250 in taxes that you would owe. Now, that $250 can be paid for in one of two ways. One way is you can choose to pay it yourself or two, you can withhold the necessary assets. For example, if I had to move a thousand over, they would withhold 25%. Then only $750 goes into the Roth account and the other $250 goes to the IRS for taxes. 

-The optimal strategy here is just to pay out of a different account. Typically, a savings account is the best way to do it because it's not earning you any interest. This allows the full thousand dollars to come over and continue working for you by earning more tax-free interest. Now, one quick note, if you are under the age of 59.5 years old, you do want to make sure you are paying the taxes from your savings. You do not want them holding taxes from the conversion! When they withhold money from the conversion, it counts as a distribution. Any distribution triggers a 10% penalty which is something you really don't want to do! 

Surprise Stealth Taxes

In correlation to Roth conversions, there are some sales taxes you may not be aware of. The two main ones are Medicare and social security.

-When we do Roth conversions, it changes our Adjusted Gross Income. If our income is too high, it can activate an increased Medicare premium. So, the more income you make will cause your Medicare premium to go up for that full year and will continue until your income goes down below the threshold. 

-The second stealth tax is Social Security. Social security is funny because of how it's taxed. There are three tiers to Social Security. If your income's within the first particular range, 0% of your social security income is subject to their tax. Then, there's another income window where 50% of your social security benefit is subject to tax. Anything past that window falls into their in which 85% or your benefit is taxable. Therefore, it's not your tax rate, but it's how much your benefit is subject to your ordering tax rate. So, if you're in that middle tier that 50% bracket after income from social security can be tax-free. The other half is taxable and you'll pay taxes at the ordinary rate, whether it be 12%, 22%, or whatever percentage you're in. The reason you want to watch for this is that when your income goes up after you collect social security, it causes more of the social security benefit to fall into that third tier. Consequently, more of it will be subject to taxes. 

Now you know the basics of what a Roth conversion is and how it all works! It's one thing to go out and learn about this stuff, but it's another thing to actually apply it to yourself. Knowledge without applying it will not amount to anything. This is a strategy you want to implement for yourself! Of course, it’s best to consult with a financial advisor, a CPA, or ideally, both. This is so they can coordinate together resulting in a well-constructed plan that prioritizes your financial health and success while avoiding any mistakes that may trigger additional, unwanted taxes. Remember, your future depends on what you do today!

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