Roth Conversions

Many people who are retired or nearing retirement worry about the fact that they weren’t able to invest in?Roth IRAs ?and Roth 401(k)s during their careers. Thankfully there are still options for investors to take advantage of the benefits of a Roth IRA account. One option is an advanced tax planning strategy called a Roth Conversion, which can have a significant positive impact on an investor’s financial plan.?Falcon Wealth Advisors ?Financial Planner Matthew Tomlin, CFP?, RMA?, EA *, joined Jake Falcon, CRPC? on?Upticks ?to discuss how Roth conversions work, who should pursue them and more. A summary of the conversation is below.??

Jake:?To start us off, Matthew, would you talk about what a Roth IRA is, as some readers may not be familiar with this type of account???

Matthew:?Sure. When you contribute to a Roth IRA, you’re contributing after-tax money. Contributing to a Roth IRA doesn’t save you any money on taxes?this?year, unlike contributing to a traditional IRA with potential pretax dollars. But a Roth does offer significant benefits in exchange for paying taxes on contributions this year.?

While you don’t receive a tax benefit today by contributing to a Roth IRA, you do in the future. The money you invest in a Roth IRA grows tax free and when you withdraw it, you don’t have to pay any taxes on it. Like a traditional IRA, you can’t withdraw from a Roth IRA without penalty until you turn age 59.5.??

Jake:?Thanks Matthew, that’s a good high level overview. Let’s now talk about Roth Conversions. What problems are we looking to solve for a client when we execute a Roth Conversion???

Matthew:?Roth IRAs weren’t an investment option before the 1990s and many of our clients were only able to invest in pretax, traditional IRAs or 401ks during their careers. Many people have the vast majority of their?retirement savings ?in these pretax accounts. In addition to having to pay taxes every time they make a withdrawal—which of course has the potential to push an investor to a higher tax bracket than where they want to be in retirement—the government also begins requiring investors to take a certain amount of money from their pretax investment accounts when the investor reaches their early to mid-70s. These withdrawals, called required minimum distributions (RMDs), have the potential to?significantly affect a client’s tax situation , estate planning and much more. Roth Conversions allow us to help a client move money from a traditional IRA to a Roth IRA, where it can grow tax free and not be subject to RMDs.??

Jake:?Yes, those RMDs force investors to typically start withdrawing about 4% annually from their traditional IRA, which increases as the investor ages and as the account increases in value. If you have $2 million in a traditional IRA, the government will require you to pull out approximately $80,000 starting at your RMD age. This is taxed as ordinary income and when it’s combined with Social Security, pension income and other sources of income, it’s possible for an investor to move into a higher-than-ideal tax bracket.??

As you discussed, Roth Conversions involve converting money in a traditional IRA to a Roth IRA, and we execute them in an effort to lower your?lifetime?tax liability.?When we financially plan for clients , we look decades into the future. We want to keep you in a lower bracket longer and lower your lifetime liability, even if it means paying a little more in taxes today.??

Let’s now discuss the nuts and bolts of a Roth Conversion, Matthew.??

Matthew:?The process is pretty simple. We will open a Roth IRA and move some or all of the money from a pretax account into this new Roth IRA account. Moving money from a pretax IRA to a Roth IRA is a one-time taxable event, so that’s a big consideration. We don’t want to move so much money that we push a client into a higher tax bracket than where they want to be. But again, once money is in the Roth, it’s growing tax free and you can withdraw from it without paying taxes after age 59.5.??

Jake:?Yes, and in addition to moving stocks from your traditional IRA, we can also move cash and bonds into a Roth IRA.??

Matthew:?And the stocks we move from a traditional IRA to a Roth are often ones we project will grow the most in value. Because growth in a Roth isn’t taxed, we want to maximize this benefit and fill a Roth with?growth-oriented stocks .??

Jake:?Good point. You mentioned how the conversion itself is a taxable event. I want to call out the importance of having money in a savings account, brokerage account or elsewhere to pay the taxes associated with the conversion. Ideally, we don’t want to use money from the traditional IRA to pay these taxes because that money will be deducted from the amount we’re allowed to convert.?

Let’s now talk about some of the rules associated with a conversion. One is that after the conversion, the money you brought over from the traditional IRA needs to stay in the Roth for five years.??

Matthew:?Yes, there is a five-year rule for each Roth conversion. If you take out any?earnings?from the Roth IRA that were made from the money you converted within five years of the conversion, you have to pay income tax on that growth. As we’ve discussed, at?Falcon Wealth Advisors , we execute Roth conversions with long-term goals and tax liability in mind. And we help clients ensure they don’t run afoul with rules like this five-year rule.??

Jake:?That’s a good point about Roth conversions being a long-term strategy. There’s no point in executing one and then taking money out of the Roth right away. If you need that money now, just leave it in the traditional IRA and pay ordinary income taxes on it upon its withdrawal.??

One reason clients pursue Roth conversions is to help their beneficiaries. If a client has more than enough money for the rest of their life, we can execute a Roth conversion so they can leave some tax free money to their beneficiaries. We can do all this because we build bespoke?financial plans ?for our clients and meet with our clients regularly. Roth conversions are complicated and I don’t suggest doing them without the assistance of a fiduciary wealth advisor. And by the way, I want to note this article shouldn’t be taken as advice. You should meet with a fiduciary wealth advisor to receive advice customized to you and your financial plan.??

What are some unknowns around Roth Conversions that could impact their long-term success and feasibility??

Matthew:?One is taxes. Tax rates are near modern historic lows, so many analysts think they will rise in the coming years. Therefore, it would stand to reason that it makes sense to execute Roth conversions now and pay ordinary income taxes on traditional IRA withdrawals while tax rates are lower.??

Of course, in the event tax rates go down even more, you could make a case that it would have been better to wait to execute a Roth conversion. But that’s not what we’re expecting. And even if they do go down, you still get the significant benefits of being invested in a Roth.??

Jake:?Another variable or unknown is your income. Roth IRAs are?not?only for younger people or lower earners. Even if you’re older and in a higher tax bracket, a Roth conversion may make sense for your financial plan. Again, we are focused on lowering your?lifetime?tax liability. I think a lot of CPAs focus on your tax liability this year, but we focus on the long term.??

Matthew:?Well said, Jake. An example of a Roth conversion that makes sense for a high earner is this: Let’s say they own a tech stock that is down 40% since they bought it, but they’re still optimistic about it. It may make sense to move this tech stock into a Roth IRA, as they will have to pay less tax on it while its value is down, and then if there is hopefully a rebound, all that growth will be tax free for the client.??

Jake:?That’s a good example. If an investor is interested in a Roth Conversion, what should they do right now??

Matthew:?The first step is to meet with your fiduciary wealth advisor and determine if a conversion makes sense for you and your financial plan. If you don’t have a financial plan, please contact our team at?Falcon Wealth Advisors . We need to see a client’s plan to see their entire financial picture before we can make important decisions, like whether to pursue a Roth conversion. A plan helps us understand your likely future tax rates, how required minimum distributions affect you, and other variables that impact the feasibility of a Roth Conversion.??

Jake:?Agreed, financial planning is table stakes if you’re going to hire a wealth advisor. We’ve taken?tax planning ?to the next level by investing in a software called Holistiplan that can scan your tax return documents and help us analyze what tax planning strategies make sense for a particular client. This is an example of how we standardize our service and customize our advice.??

There’s no need to wait until later in the year to review your tax situation. If you’re a client, let’s meet now. We can use Holistiplan to analyze your recent tax returns and come up with a plan that includes strategies like Roth conversions. Financial planning and?tax planning ?is a conversation that needs to happen every single year, as both your life and the tax code can change.??

Matthew:?And the earlier in life we can have these conversations, the better. Ideally we will have a long-term plan laid out well before you reach your early to mid-70s and are subject to required minimum distributions.??

Jake:?And you don’t have to be in your 50s, 60s, 70s to take advantage of a Roth conversion. It may make sense for someone in their 30s or 40s, as they will have more time to take advantage of a Roth’s tax-free growth. I’ve actually executed Roth Conversions for myself.??

Are there any common mistakes people make when executing a Roth Conversion, other than not paying attention to the five-year rule we discussed???

Matthew:?Sure. One is converting too little money. Even if you have to pay a little more in taxes this year, Roth Conversions have the potential to lower your lifetime tax liability significantly, as we’ve discussed.??

But you also don’t want to convert too much and get pushed into a high tax bracket, which could mean you have to pay more for Medicare and higher taxes on Social Security distributions. All of this is tied to your taxable income and your tax bracket. Don’t fall victim to a “tax torpedo.”???

Jake:?Indeed. You don’t want to ballpark this. Work with a fiduciary wealth advisor who has access to software like Holistllan to ensure you’re converting the proper amount for your financial plan.??

Regarding converting too little, I encourage clients not to be penny wise and dollar dumb. These numbers are simply examples, but of course it makes sense (if you can afford it) to pay $10,000 in taxes this year to save $100,000 in the coming decades. I’ve seen how much required minimum distributions frustrate clients in their 70s and beyond, so if you’re able to make decisions in your 50s or 60s to lessen their impact, I would encourage you to work with your fiduciary wealth advisor to make it happen. Let’s take advantage of these historically low tax rates, as well.??

Thanks for joining me, Matthew. We know financial planning and tax planning can be complicated. We can work with your CPA to ensure we’re on the same page as we aim to lower your lifetime tax liability. If you want to learn more about all of our team’s capabilities, please contact me today. You can reach me directly at?[email protected] .??

Clients choose to work with us to enhance their financial literacy and explain exactly what?their?financial plan means to?them.?

Hightower Advisors, LLC is an SEC registered investment adviser. Securities are offered through Hightower Securities, LLC member FINRA and SIPC. Hightower Advisors, LLC or any of its affiliates do not provide tax or legal advice. This material is not intended or written to provide and should not be relied upon or used as a substitute for tax or legal advice. Information contained herein does not consider an individual’s or entity’s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. Clients are urged to consult their tax or legal advisor for related questions.?