While some Social Security strategies have been discontinued, there are still a few under-utilized strategies…
There has been a lot of talk about Roth conversions so I wanted to help bring greater clarity to the issue. First, we will discuss the differences between a Traditional Individual Retirement Account (IRA) and a Roth IRA. Second, we will address what a Roth conversion is. Lastly, we will consider why and when would you do a Roth conversion.
First things first: What is the difference between a Traditional IRA and a Roth IRA? A Traditional IRA account is a pre-tax investment, which means the assets in the account are income-tax–deferred. For example, let’s say you make $50,000 in wages and have $5,000 deducted from those wages then transferred to your 401(k) or IRA. As a result, at the end of the year your W-2 would indicate that you only have $45,000 of wage income even though your gross income is $50,000. As the money sits in the 401(k) or IRA and earns interest, dividends, and capital gains, those earnings are also tax-deferred until withdrawn. Meaning, not until you withdraw the Traditional IRA assets would you report the full withdrawal amount as income. For example, if you make $50,000 in wages and withdraw $5,000 from a Traditional IRA, at the end of the year you would report $55,000 of income.
In the case of a Roth IRA, however, the opposite is true. If you make $50,000 in wages and have $5,000 withheld and then transferred into a Roth 401(k) or IRA, at the end of the year you would still report $50,000 of income. No matter how much money you make in interest, dividends, and capital gains, when the Roth monies are withdrawn they are completely tax-free. For example, if you make $50,000 in wage income and withdraw $100,000 from your Roth account, at the end of the year you would still only report $50,000 of income.
Second, what is a Roth conversion? Roth conversions can only be made from a pre-tax retirement account, such as a Traditional IRA, Traditional 401(k), or Traditional 403(b). A Roth conversion occurs when any or all of the tax-deferred funds in a Traditional pre-tax retirement account are moved to a Roth after-tax retirement account. HERE IS THE CATCH: In the year of the conversion you must report as income on your tax return any pre-tax Traditional monies converted to the Roth account. For example, if you make $50,000 of wage income and convert $10,000 of your Traditional retirement monies to a Roth retirement account, at the end of the year you would report $60,000 of taxable income. When you move a Traditional 401(k) to a Traditional IRA it is considered to be a direct rollover and tax-deferred. If, however, you move your Traditional pre-tax 401(k) to a Roth IRA it is considered to be a taxable rollover conversion. Conversions can be very beneficial, but you must be ready to pay taxes on the converted amounts.
Lastly, when and why would you do a Roth conversion? The key to a successful conversion is comparing your tax bracket at the year of conversion to your assumed tax bracket the year of withdrawal. If you expect to be in the same tax bracket or higher in the anticipated year of withdrawal then your decision to convert will prove to be rewarding.
There are some obvious opportunities that one needs to consider before making a Roth conversion. For example, be mindful of the year that you decide to make a big charitable donation. The new tax law encourages Americans who are charitably inclined to make large donations in 2018 to a Donor Advised Fund and then make future charitable contributions from the Donor Fund. When we do this for clients we typically will couple it with a Roth conversion because we are lowering their taxable income substantially. In addition to becoming a charitable donor, if a client who owns a business, especially a new one, reports a tax loss in a fiscal year this may be an opportunity to turn lemons into lemonade. We can use that loss to move monies from a pre-tax IRA to a tax-free Roth and the business loss will help offset the taxable income on the conversion.
A client’s retirement may present yet another a conversion opportunity: Because the client’s wage income has stopped, we may be able to control the amount of taxable income reported in retirement. For example, assume a couple who are both 64 years of age and made $200,000 in wage income retired in December 2017. Their retirement monthly budget is $15,000/month, or $180,000/year. Further assume that the clients have $1,000,000 of pre-tax retirement funds and $2,000,000 of other taxable investments. The clients have chosen to wait until they are older to collect Social Security benefits, so we would not have that income to report. In this scenario, we would withdraw their $15,000/month of living needs off of the $2,000,000 of other taxable investments. The only taxable income reported on the $2,000,000 account is the interest dividends and realized gains on this portfolio, which would be estimated at only $60,000. The only taxable income in this scenario, therefore, is $60,000. I could then do a $50,000–$80,000 conversion at a substantially reduced tax bracket, compared to the tax bracket that the clients were in when they were working or the future tax bracket they will be in when they begin to collect Social Security benefits.
The year of one’s death, if a client is single, is another conversion opportunity; this is not ideal, but the strategy may still work very well. When an individual passes away their taxable income is only recorded up to the date of death. If someone dies in the first few months of the year, then that person’s reportable income for those few months may be very low. Thus, if it is possible to have advanced notice before a client dies we may be able to do a Roth conversion to increase income in this expected low-income year.
One final opportunity to benefit from a low-tax–bracket year is if you move from a high-tax state to a low-tax state. For example, many of our clients live in the state of Maryland. When they retire many choose to domicile in another, less-expensive income tax state, such as income-tax–free Florida. Maryland adds an additional 8.5% of taxation to any income that a Maryland resident makes over and above federal taxation. Moving to an income-tax–free state may be just the time to consider a taxable Roth conversion.
Everyone who has a pre-tax IRA should establish a Roth IRA with at least $100. The reason for this seemingly trivial move is that Roth tax-free status requires the account holder to have a Roth account in existence for 5 years. Even if the Roth conversion concept is worthless for years, getting past the first 5 years is of benefit for future planning.
The Roth IRA is the most powerful asset-accumulation vehicle in the United States. Warren Buffet attributes much of his success to buying stocks that he can hold forever, because the compounding interest would occur without taxation unless the stocks were sold. A Roth IRA would have made Buffett far richer, because even when sold it would have been tax-free. Make sure you have an advisor that knows how to help you develop a wise Roth strategy.
Please contact your Consulate relationship manager if you want more details on your specific situation.