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Canopy Commentary - Roth Conversions on Sale

Canopy Commentary - Roth Conversions on Sale

October 19, 2022

Every year around this time, financial planners talk to clients about Roth conversions.  This year, however, a conversion of funds from a Traditional IRA to a Roth IRA may be even more valuable.

Roth IRAs are attractive for several reasons.  With Traditional IRAs (and qualified plans like 401(k)s), the money one contributes is not taxed, but you must pay ordinary income taxes when the funds are withdrawn, which might be years in the future.  The Roth reverses this; your contribution is made with after-tax dollars, but then there's no tax on distributions during retirement (after age 59 ½ ).  If you might be in a higher tax bracket when taking distributions in the future, this strategy provides a net gain.

Another interesting thing about Roth IRAs is that, unlike Traditional IRAs, they do not have required minimum distributions (RMDs) at age 72.  So long as the funds remain in the account, both Roth and traditional IRAs give you the benefits of tax deferral, which eliminates a significant drag on the growth of your money.  If you can afford to keep your money in the Roth account, and take retirement income from other sources, then the deferral can go on longer.

Also, having money in a Roth IRA gives you much more control over your tax bracket in retirement.  For instance, you might take out just enough from your Traditional IRA to fill the 15% bracket, and then take the remainder of your living expenses out of your taxable accounts and Roth IRA.  This kind of planning might help higher-income retirees reduce taxes on their Social Security income and avoid higher Medicare premiums.  If a married couple can keep Traditional IRA distributions low enough that their taxable retirement income is below $44,000, they would pay taxes on just 50% of their Social Security income; otherwise, they pay taxes (at a potentially higher tax bracket) on 85% of those benefits.  The higher Medicare premiums start at $182,000 of joint income.

Finally, a Roth IRA is not subject to income taxes for the next generation.  If a non-spouse beneficiary inherits an IRA, they have 10 years to withdraw the funds.  While those distributions are taxable from a Traditional IRA, Roth distributions are tax-free. 

So why is this an especially good year to consider Roth conversions?  Remember that you are paying taxes today on the amount that is moved from a Traditional IRA to a Roth.  Now that the markets have declined by more than 20%, people can transfer more shares (of stocks, mutual funds, or ETFs) today than they could have last year for the same tax payment. 

Put another way, Roth conversions are more than 20% cheaper, taxwise, than they were at this time last year.  Roth conversions are on sale, for who knows how long, a silver lining of the bear market.

Every situation is different, so there should be an individual assessment of your situation before you pull the conversion trigger.   Fortunately, the law allows for partial Roth conversions--moving some of the money over, rather than all of it—so that each conversion can be tax-managed to avoid putting you into a higher tax bracket.