Critical Tax Considerations Before Converting to a Roth IRA

Hello everyone and thank you for joining me. Roth conversions are possibly one of the most impactful tools over the lifetime of someone's financial plan. For those unfamiliar, Roth conversions are when you take money from pre-tax retirement accounts, pay taxes on them now, and then have the funds continue to grow tax-free in a Roth IRA. The big goal of doing them is to have more control over your own tax picture to save on lifetime taxes. But oftentimes they're thought of as a silver bullet, right for everyone at every point of their life. So today, I'd like to spend a few minutes talking about some considerations before converting. Let's dive in.

First, tax rates. You've probably heard, or maybe even noticed on your return, that federal tax rates are at historic lows. But that doesn't mean your own personal tax rate is at its historical low. While you're working, a Roth conversion is additional income taxed at your highest rate. By waiting until you're in retirement, you no longer have the forced income of a salary very quickly filling up your lower tax brackets. And those brackets can be used more effectively and creatively during that time where conversions may be your first source of income rather than your last. And for those currently in the 32, 35, or 37% bracket, converting now may mean paying a lot in unnecessary taxes.

Which brings us to our next point. Paying for the conversion. A Roth conversion comes with a tax bill. And when making the decision of how to pay for the conversion, you can either withhold taxes or use outside funds like a checking or savings account. While thinking about that choice, let's not forget that a Roth conversion is technically a withdrawal from a retirement account. This means any money that doesn't end up in your Roth IRA is subject to the 10% early withdrawal penalty if you're under 59 and 1/2. Yes, that's right. If you convert funds before 59 and 1/2, any amount of taxes withheld from the conversion will be subject to a 10% penalty. So, for those in their working years, taxes withheld are not only dollars forever gone from the ability to compound and grow, you also get a slap on the wrist from Uncle Sam.

Now, most often when Roth conversions are discussed, the conversation begins and ends with the federal tax impact. Which brings us to our next point. Additional impacts from converting. In addition to federal taxes, Roth conversions can also impact your taxes in other ways that you may want to think about before making the decision. Where you live currently may not be the place you retire in. If that means going from a state that does tax Roth conversions to a state that does not, you could be paying thousands of dollars in taxes for no good reason. And for all others, here are just a few other impacts of conversions: potentially making more of your investment income subject to the 3.8% Medicare surtax, loss or reduction of other deductions at the federal or state level, and Medicare premium increases.

So, with all these different considerations, does that mean we're not in favor of Roth conversions or don't recommend them? Absolutely not. Roth conversions may be an incredible tool when used at the right time in someone's life. Which is why at Presilium, we review our clients' tax returns annually, identifying opportunities of when it makes sense to convert and when it doesn't on a year-over-year basis, and discuss all impacts of conversions before making a recommendation. Thanks for watching and until next time.