Brad Tinnon

Brad Tinnon

3 Reasons to do a Roth IRA Conversion

In today’s blog post, learn 3 reasons why it may be advantageous for you to start converting some of your IRA to a Roth IRA (known as a Roth IRA Conversion). Doing so could significantly improve your net worth and protect you from an uncertain political future.

NO DIFFERENCE IF TAX BRACKET STAYS SAME

Let me start out by saying that if you are in the same tax bracket in the future as you are today, THERE IS NO DIFFERENCE BETWEEN AN IRA AND A ROTH IRA.

I think an example will help you to see this. Let’s make the following assumptions: 25% tax bracket, $100,000 IRA account, 20 year investment time frame, and 10% investment rate of return.

IRA

After 20 years, your IRA will be worth $672,750. If you sell the entire investment you will owe $168,187 in taxes ($672,750 x 25% tax bracket), leaving you with an ending investment value of $504,563.

ROTH IRA

A Roth IRA is funded with after tax dollars. Therefore, if you have $100,000 you must pay taxes on this money before you invest it in a Roth IRA. At a 25% tax bracket, you would be left with $75,000 to invest ($100,000 – $25,000 taxes). After 20 years, your Roth IRA will be worth $504,563; the exact same as the IRA.

So, as you can see there is no growth advantage between the Roth IRA or IRA if tax brackets remain the same. However converting an IRA to a Roth IRA can provide some distinct advantages even if your tax bracket does remain the same in the future.

PROTECTION FROM A FUTURE CONGRESS

It’s no surprise to you that our country is in a tremendous amount of debt. This alone could lead to much higher taxes in the future. Additionally, the Congress changes every 2 years and the President every 4 years. Depending on their agenda, tax brackets could be much higher than today.

As a general rule of thumb, we prefer that clients have a 3 Bucket Strategy which includes money in pre-tax accounts, tax free accounts, and taxable accounts. Having money in different buckets will help to protect you from whatever taxes happen to be in the future.

One of the main reasons to have money in a Roth IRA is to protect you from rising tax brackets. If you are in the 25% tax bracket today, but that same bracket increases to 50% in the future, you will likely not want to withdraw money from your IRA. Since an IRA is usually fully taxable, you will lose 50 cents for every dollar you withdraw. So, if you withdraw $100,000 you would only net $50,000. 

However if you had a Roth IRA, you would be able to withdraw the full $100,000 tax free.

LESS RMD

IRS rules require you to begin withdrawing money from your IRA accounts once you reach the age of 70 1/2 (leave it to Congress to establish such an obscure age). This is known as the Required Minimum Distribution (RMD). Even if you don’t need the money you are forced to withdraw it. This then causes you to have taxable income as well as possibly subjecting your Social Security income to taxation. More on that in a moment.

Roth IRAs, on the other hand, do not have this age 70 1/2 restriction. Therefore, if you need to withdraw money during high tax bracket times, you could do so from your Roth IRA and not be subject to taxation. Or if you don’t need money at all then you wouldn’t have to withdraw it from your Roth IRA.

And the more money that you convert from an IRA to a Roth IRA means that your IRA account balance will be lower and therefore will face less RMD.

LESS SOCIAL SECURITY WILL BE TAXABLE

One of the lesser known tax rules is as follows. If your only income is from Social Security then NONE of it is taxable. However, if you have taxable income from pensions or IRAs then up to 85% of your Social Security could then become taxable. 

If all of your money is in pre-tax accounts (IRAs and 401ks) then you will be forced to take RMD at age 70 1/2. This then could force you into a higher tax bracket and cause some of your Social Security to be taxable. Paying all this extra unwanted / unnecessary tax is a wealth destructive move. 

However, by converting some of your IRA to a Roth IRA you can protect yourself from some of this Social Security tax.

HOW DOES A ROTH IRA CONVERSION IMPACT YOUR NET WORTH

It’s virtually impossible to answer this question since we don’t know what future tax brackets will be. The primary reason for a Roth IRA Conversion is to provide protection from uncertain future tax rates. But an added benefit could be a significantly improved net worth. 

Think about this logically for a second. If your tax bracket rises in the future and you leave your IRAs as is, then you will eventually withdraw money at the higher tax bracket. However, if you instead do a Roth IRA Conversion, you will pay lower tax today and protect yourself from the higher rate in the future. This alone would increase your net worth.

In addition to that, the less RMD that you have to take out means that your money can continue it’s tax deferral which can significantly improve your net worth. The power of this tax deferral is huge. 

WHAT ABOUT HIGH INCOME INDIVIDUALS

Should a person convert their IRA to a Roth IRA if they are in a high tax bracket? If a person is in high tax bracket, say 35%, then it is a tall order for them to convert their IRA because they would be forced to pay 35% taxes today. 

However, if taxes are even higher than 35% in the future, then a Roth IRA Conversion can make sense today. No one knows the future, so it’s impossible to know what the best solution is. 

There is no right or wrong answer here, but we generally don’t recommend that people convert if they are in a tax bracket greater than 15%. Reason being is that you are guaranteeing that you pay a high tax rate today (25% or higher). Additionally, there may be opportunities to convert in the future when you are in a lower tax bracket.

Believe it or not, many people are often times in a low tax bracket when they first step into retirement. This is because RMD is not yet due and because distributions from investment accounts come from taxable accounts first. It’s usually wise for a person to let their tax deferred / tax free accounts (IRAs, 401ks, and Roth IRAs) continue to grow untouched and instead, tap into their taxable accounts if money is needed. 

If you’ve been a high income individual for a long time, then you likely didn’t qualify to contribute to a Roth IRA in the first place. As such, if you want to have Roth IRA exposure, then you would have to convert your IRA/401k. Or you could engage in this unique Roth IRA strategy for high income individuals.

SHOULD YOU CONVERT 100% OF YOUR IRA

You may be wondering if you should eventually strive to convert all of your IRA to a Roth IRA. If you are in a very low tax bracket, then go right ahead. But if not, then I would suggest leaving some money in an IRA. The reason is because tax brackets could be lower in the future. And doing a Roth IRA Conversion today could cost you more in taxes than it would in the future. It all comes back to the 3 Bucket Strategy. You want to give yourself options no matter what tax brackets happen to be.

In conclusion, it can be difficult to know whether or not you should engage in a Roth IRA Conversion since no one knows what the future holds. But the lack of crystal ball is reason enough to give this strategy some consideration. In addition to protecting you from a future congress, RMD, and taxable Social Security, a Roth IRA Conversion may even improve your net worth.  

I would love to hear your thoughts on whether or not you’ve engaged in a Roth IRA Conversion. Do you think it’s worthwhile? Feel free to share any questions, comments, or experiences you have below. 

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Brad E.S. Tinnon
CERTIFIED FINANCIAL PLANNER™
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