The goal of tax planning is to pay income taxes at a lower rate over the course of your lifetime. Roth conversions can help you manage your current tax bracket while keeping an eye on future tax rates. Done correctly, Roth conversions can be a powerful way to manage your tax liability.
To be truly tax-efficient, you should have a deliberate and systematic Roth conversion strategy. One that is aligned to your priorities and your financial goals.
Here are 5 reasons to review your Roth conversion strategies each year.
Reason #1: Changes in the tax law may impact your strategy.
It seems that the tax law is always changing. In the period from 2017 to 2020, there were 3 laws passed with significant impacts (both permanent and temporary) to the tax code:
- The Tax Cuts & Jobs Act of 2017
- The SECURE Act of 2019 (SECURE stands for Setting Every Community Up for Retirement Enhancement)
- The CARES Act of 2020 (Coronavirus Aid, Relief, and Economic Security)
Each of these law changes provided both challenges and opportunities for Roth conversions.
For example, the CARES Act suspended required minimum distributions (RMDs) on IRAs and qualified retirement plans for 2020. This allowed people who would otherwise have been forced to take a distribution to make a choice:
- Use that same distribution as a Roth conversion instead
- Simply keep the money in the IRA and pay a lower tax bill in 2020
Even if there aren’t new laws, there are changes every year. Here are some of the things that change every year:
- Income limits and contribution limits for Roth IRA contributions
- Income limits for the deductibility of traditional IRA contributions
- Contribution limits for IRAs and workplace retirement plans, like 401k or 403b plans
Finally, there are always hotly contested proposed changes. These are some of the things you might see being discussed on CNBC as Congress debates an upcoming bill. Here are some items that were discussed in 2021:
- Whether or not to disallow backdoor Roth IRA conversions
- Imposing income limitations for people with a high IRA balance (over $10 million)
Your Roth strategy needs to keep up to date with the new tax rules. But the tax law might not be the only thing that changes.
Reason #2: Your tax situation might change.
Many people think that once you retire, your finances get simpler. And sometimes they do.
That doesn’t mean that your tax situation gets simpler. Every year, you need to review your tax situation to see what might be going on.
Here are several things you should be looking out for each year:
You might get pushed into a higher tax bracket.
Even in retirement, many people actually experience an increase in taxable income, resulting in higher taxes.
Most of the time, it’s because of required minimum distributions (RMDs). But it could also be because of:
- Capital gains on sales of investments (or investment property)
- Deferred compensation
- Retirement plan distribution (other than RMDs)
If this happens, you’ll probably want to look at your Roth conversion plan to make sure you remain in a desirable tax bracket.
You might go into a lower tax bracket.
Of course, the opposite might happen. Your adjusted gross income might decrease, resulting in a lower federal income tax.
Your deferred compensation might completely pay out,. You might not have capital gains this year. Or for some other reason, you might simply have figured out a way to lower your tax bill for the year.
In this case, you’ll want to see if this is a lasting trend. Or if it’s just a one-time event.
In some instances (like avoiding capital gains), it might be completely sustainable. In cases, there might have been a one time tax break. For example, the CARES Act eliminated RMDs for only the tax year 2020.
A good idea would be to review your tax situation. Use this opportunity to see how much money you can convert at a lower marginal tax rate.
You might experience a change in tax filing status.
In retirement, the most common change in tax status is when someone loses a spouse. This could result in higher tax rates for the surviving spouse.
Why? Because given the same income, married taxpayers pay less in taxes than single filers. And most of the time, income sources don’t change all that much in retirement.
However, many people also get married during retirement. Since married couples get that tax break, this could be a great opportunity. The opposite happens during a divorce.
All of these are legitimate reasons to take a look at your taxes for challenges (or opportunities).
And even if your tax status doesn’t change, your tax bill almost always does. The best strategy is to conduct mid-year tax reviews with your tax or financial advisor.
Mid-year reviews are a perfect time to see how much you should be paying in taxes as you do your Roth conversions, as well as how much you might owe or expect as a refund at tax time. And to make sure your Roth conversion strategy is intact.
Reason #3: Life changes might occur.
As mentioned above, significant life changes could happen that might directly impact your taxes, like a change in tax filing status. But more importantly, there might be changes in your life, which indirectly impact your taxes.
Perhaps there are life events that require more money than you originally thought. And you’re pulling more from your IRA. Perhaps you’re taking some investment gains out of a taxable account to pay for home repairs.
Maybe you’ve started taking Social Security. And you need to account for that in your Roth conversion plan.
The bottom line is that as changes in your life happen, you should be looking to see if you need to make adjustments to your Roth conversion strategy.
Reason #4: Your investments might have an impact.
If you manage your own investments, this might be an opportunity to evaluate the investments inside your retirement accounts.
If you’re working with a financial planner, make sure you ask them. Most financial advisors use investment strategies that don’t account for taxes. So you might need to make sure your investment manager is keeping an eye on the stock market’s impact on your Roth conversions.
While your investments might not have a direct impact on your Roth conversion strategy itself, here are some things to be mindful of:
Are your investments in the right location?
What does this mean?
For tax-efficiency, you may consider how each type of account is invested, based on the tax treatment of investments inside the account.
For example, your highest-earning investments might do better in a Roth account. You’ve because you’ve already paid taxes on the Roth contributions. You want your superstar investments here so you can take advantage of the tax-free withdrawals. Think small cap and overseas stocks, low-cost mutual funds, and exchange-traded funds.
Conversely, let’s imagine you have taxable bonds or CDs as part of your portfolio. You might want them to be in your pre-tax retirement account. Interest income from bonds or CDs is taxed at ordinary tax rates. Since you don’t want to pay taxes on the interest every year, but these investments won’t earn as much, a traditional IRA is the best place for them.
Finally, conservative stock investments (like blue chip and dividend-yielding stocks), would do well in a taxable account. Qualified dividends are given preferential tax treatment, as are capital gains. Also, if you are charitably inclined, you can simply gift the appreciated investments. You can take the full tax deduction based on the value of the investment, but you don’t have to pay capital gains tax.
Do you need to rebalance?
You should always evaluate your Roth conversion strategy to see how you might rebalance your investments.
Stock market fluctuation causes asset allocations to shift over time. For example, a 60/40 portfolio (60% stock, 40% interest-earning investments) might shift to 65% or 70% stock in a rising stock market.
If you’re making huge conversions (like a mega backdoor Roth conversion), you might inadvertently shift the tax location of your more lucrative investments. So you should make sure to rebalance accordingly.
Is there an impact on the timing of your Roth conversion?
For example, let’s imagine that you had planned to do a Roth conversion later in the tax year.
However, the stock market has been in a slump recently. We know that we’ll eventually recover, but you may considering moving your Roth conversion up to take advantage of the down stock market. That way, you convert more shares of your securities at the lower price point. Then, as the stock market recovers, those holdings increase in value tax-free.
Of course, the opposite might be true. You might convert fewer shares at a higher price point if the stock market is on a tear.
However, don’t let the tail wag the dog here. As long as you stay with the planned dollar amount, it’s probably better to make the conversion anyway instead of waiting until next year.
And if you don’t do your investments, these are all fair questions to talk about with your financial advisor during your tax planning meeting.
Reason #5: Your priorities might change.
It’s good to revisit your Roth conversion strategy just to make sure that your assumptions and financial goals haven’t changed.
Roth conversions might have been important when you first started. But perhaps they’re not the top priority now. Here are a couple of examples:
Charitable contributions are more important.
Perhaps you’ve decided that you want to contribute more to charity.
If that’s the case, then it doesn’t make sense to pay any taxes for Roth conversions. If the money is going to charity, why pay taxes?
If you are age 70 1/2 or older, you can make qualified charitable distributions (QCDs). And you can use QCDs to offset RMDs (up to $100,000 per year). So if you don’t need the money from your IRA, you can donate it to charity without paying taxes on it.
Certainly, this is something that people struggle with when trying to balance charitable contributions and Roth conversions.
It might be more tax-efficient for your beneficiaries might be able to pay the taxes on IRA distributions.
You might have wanted to pay taxes on Roth conversions so that your beneficiaries didn’t have to.
Some people do this even if they’re in a higher tax bracket than their heirs. But maybe you changed your mind.
Your tax bracket might not look that bad when you start having to take RMDs.
Many people assume that Roth conversions are an ‘all or none’ game. But there’s nothing about your Roth conversion strategy that says you have to avoid RMDs.
Perhaps you’re not on track to convert everything into a Roth, but you might have converted enough. And if you’re able to keep your current taxes low, maybe you don’t need to do much more.
As you review your strategy with your tax advisor each year, they should help you with this.
Roth conversions can be a great way to make the most of your retirement savings. Done right, you can keep more of your hard-earned tax dollars and enjoy tax-free growth from your investments.
So it’s important to have a Roth conversion strategy. But Roth conversion strategies can be different for different people. So it’s even more important to have a system in place to periodically review it.
After all, when life happens and changes occur, those changes might warrant adjustments to your carefully well-thought out strategy. If you review your strategy each year when you do your tax planning, you’ll be in a great position to make those adjustments.
After retiring from a 24-year career as a Naval officer in 2017, Forrest became a financial planner to help people achieve success in managing their personal finances. In 2022, he sold his partnership stake in his financial planning firm to focus on helping people full-time through his writing.
Featured in: Forrest’s writing has been featured in the following publications: Forbes, Military.com, NerdWallet, Yahoo Finance, The Military Guide, The Military Wallet, Christian Science Monitor, and many other publications.
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