Roth conversions are a powerful tool to utilize for various reasons when it comes to maximizing retirement savings. A Roth conversion is an essential part of the back-door Roth IRA strategy (for high-income earners) who otherwise can’t make a direct contribution to a Roth. It’s also a strategic way to “max out” marginal income tax brackets each year. As with all retirement account decisions, it’s essential to consider the tax consequences of a Roth conversion. This article will explore the various strategies a Roth conversion can utilize to ensure you’re making the most of your retirement savings!
Pre-Tax versus After-Tax
Before jumping into Roth conversion strategies, it’s essential to have a basic understanding of the tax treatment of retirement accounts. Retirement accounts, for the most part, can be categorized as either pre-tax or after-tax. Meaning, any contributions made to pre-tax accounts, allow for a tax deduction in the year the contributions are made. In turn, when the individual retires, withdrawals are taxed at their income tax bracket in the year funds are withdrawn.
On the other hand, after-tax contributions aren’t tax-deductible in the year contributions are made. With the caveat that withdrawals are made tax-free in retirement.
For example, let’s say an individual contributes $19,000 to their pre-tax 401(k). This individual is in the 32% federal tax bracket. They’re essentially saving $6,080 in taxes by utilizing the pre-tax deduction. Twenty years go by, and the individual has retired. To support his/her retirement lifestyle, they’re relying on retirement account assets. Due to changes in the tax code and inflation, this individual needs $150,000 per year distributed from their pre-tax retirement account to support their lifestyle. Withdrawing 150k in pre-tax assets also means the individual recognizes 150k in income. If the tax code puts this individual in a marginal tax bracket less than 32%, then they’re paying less in taxes on those funds than they did 20 years prior. If they’re paying more, they haven’t “lost” so to speak, but it can be argued they should’ve utilized the after-tax option.
The decision of whether to contribute to pre-tax or after-tax retirement accounts ultimately comes down to taxes. It’s a guessing game as to what taxes will be in retirement for young professionals. Therefore it can be argued that it’s advantageous to pay taxes today (based on relatively low marginal tax rates) and allow assets to grow tax-free. However, for higher-income individuals or families who may fall in the top 3 marginal tax brackets (32, 35, 37%) it can make sense to make contributions pre-tax for the tax deduction.
The Backdoor Roth IRA
Now that you’ve got a basic understanding of tax treatment of retirement accounts, we can dive into specific Roth conversion strategies! The first that comes to mind is the backdoor Roth IRA. This strategy is for high-income earners who couldn’t otherwise make a direct contribution to a Roth IRA. Once income hit’s a particular limit, the IRS doesn’t allow you to make contributions to a Roth IRA.
However, regardless of income, individuals are always allowed to make non-deductible Traditional IRA contributions. Meaning, you’re not getting any tax deductions for contributing to a pre-tax IRA, but you’re still getting funds into an account that grows tax-deferred (pre-tax IRA). Now, you could keep funds in the non-deductible IRA, OR you can complete a Roth conversion and transfer those funds into a Roth IRA. If you complete the Roth conversion immediately after contributing, there won’t be any tax consequences since the funds haven’t had time to grow and haven’t been invested. Once the funds are converted into the Roth IRA, they can be invested tax-free as opposed to tax-deferred!
Before using Roth conversions in this manner, it’s essential to be aware of potential pitfalls. The main concern is whether you own any other pre-tax IRA’s. If so, the pro-rata rule is employed to determine how much of the conversion is “taxable” since the IRS will group all the pre-tax IRA assets into one when calculating tax consequences. For example, imagine you have a Rollover IRA with $100,000, and you’ve opened a traditional IRA to employ the backdoor Roth IRA strategy. When using a Roth conversion on the traditional IRA assets, you’re still exposing part of the $100,000 to tax liability since it’s included per the pro-rata rule. For example, if you tried to convert $5,000 of the $100,000 then only $250 would be converted tax-free, or 5%. The key is to ensure there aren’t any other pre-tax IRA’s to avoid any unexpected taxes.
Maxing out Marginal Tax Brackets
As described earlier, the critical decision in whether to contribute to a pre-tax versus after-tax retirement account is determining whether you’ll pay less or more in taxes today versus in retirement. Nobody knows what taxes will look like when we retire; it’s entirely up to the government and their policies at that point in time. Therefore, to take the guesswork out of predicting tax brackets, if you’re in the early stages of your earning potential, it likely makes sense to utilize some after-tax contributions.
At the end of the calendar year when income is very predictable, compare the difference between what the high end of your federal marginal income tax bracket is with your estimated income. For example, let’s use a single filer with $150,000 in income. The top end of the 24% tax federal income tax bracket is $160,725. $160,725 – $150,000 = $10,725. In this example, this person could complete a Roth conversion on $10,725 of pre-tax retirement assets and pay 24% income on those dollars. This would likely be a great strategy to employ due to this person being in the relatively early stages of their earning potential and historically lower income tax rates.
Let’s view another example where this strategy can become even more powerful — a married couple where both spouses take maternity and paternity leave. Their income is lower for the year than it typically is and results in a combined income of $150,000 near year-end. If they’re filing jointly, this leaves them with $18,400 until they ‘jump’ into the next marginal income tax bracket. By maxing out their current bracket using Roth conversions, they’ll only pay 22% on the converted amount. Whenever your income is lower than average, it can be a good idea to employ a Roth conversion.
The Bottom Line
Roth conversions can be a powerful tool in navigating retirement assets. Whether that’s using the backdoor Roth IRA strategy to enhance your retirement savings or strategically maxing out marginal income tax brackets each year, Roth conversions can help ensure you’re being tax-efficient and allowing more of your retirement assets to grow tax-free.
If you’re unsure whether a Roth conversion makes sense for you, schedule a free consultation today!