When developing your Roth IRA conversion strategy, figuring out your Roth conversion tax bracket is one of the most common considerations. One of the key goals of doing Roth conversions should be to keep your marginal tax bracket as low as possible.
When looking at your tax bracket, you’ll want to consider future tax rates, not just keeping your current rates low. To do this, you might try to determine what the ‘ideal marginal tax bracket’ might be for your situation. From there, you would then to use that as a target for planning your annual Roth conversion amounts.
However, this might not be as easy as it sounds. The goal of this article is to help IRA owners understand some of the obstacles that might present themselves. This way, you can determine what your ideal tax bracket might be. Let’s start with what’s obvious.
You want to keep your tax bracket as low as possible.
That’s pretty straightforward. But what makes this challenging is that you’re probably not looking at this from the perspective of just one year. You have to balance the goal of keeping your federal tax low in the year of conversion as well as in future years.
For depending on individual circumstances, it might be a realistic goal to do all Roth conversions while remaining in the 12% marginal tax bracket.
This is an ‘ideal’ tax bracket not just because it’s one of the lower tax rates. At this marginal bracket, capital gains from investment sales are taxed at 0%. This is great for people with lots of appreciated stocks or mutual funds in their investment accounts.
Being in the 12% tax bracket enables many people to unwind their capital gains over time without having to pay taxes.
But you might not be in this position. Let’s imagine that you and your spouse have $5 million in your IRAs. You’re in your early 60s, so you’ve only got 10 years before you take required minimum distributions (RMDs).
You probably won’t be able to convert everything at the 12% tax bracket. And once you’ve started taking RMDs, they might be high enough to keep you out of the 12% tax bracket.
For some people, the ‘ideal’ tax bracket for Roth conversions might be 22%, 24%, or even 32%. 32% seems like a very high tax bracket. But you might consider this strategy to avoid higher tax rates like 35% or 37%. But to do this, you need to look at all the factors involved.
Obstacles keeping you out of a lower tax bracket.
Over the course of your lifetime, there are a variety of specific circumstances that can interfere with your Roth conversion strategy. But we can break them down into several categories, which we’ve outlined below.
Your income level is probably the biggest driver of a Roth conversion strategy. Specifically, changes in your income as you go through your career.
Most people have a typical career progression:
- Enter the workforce at a low adjusted gross income. Pay a low tax rate.
- Probably best opportunity to make Roth IRA contributions
- Over the course of a career, pay raises and promotions.
- Eventually reach Roth IRA income limits.
- Start contributing to a traditional account instead.
- Eventually retire.
- Lower rates mean opportunities for Roth conversions
- File for Social Security benefits.
- Could raise taxable income.
- If RMDs apply, will likely raise taxable income over time. Thanks to the SECURE Act, RMDs now start at age 72.
One of the most common goals of Roth conversions is to avoid RMDs. However, below are some other income-related factors worth considering:
Pensions: If you have a taxable pension, you’ll have less opportunity for Roth conversions at the same tax bracket.
Social Security (and when to decide to start taking it, if you haven’t already): You can control the timing of this between ages 62 and 70. Filing later gives you more opportunity to do Roth conversions.
Your employment situation: Some people continue to work long after work has become optional for them.
Deferred compensation: Usually gets paid out when you retire or separate from the company. They might give you several choices:
- Lump sum: Probably will cause a one-time spike in your taxable income. This could force you into a higher tax bracket and pay higher taxes.
- Multiple-year payout: Might keep you in lower tax brackets, but limit your Roth conversions for several years.
Stock options: Balancing your investment objectives vs. avoiding a big tax bill.
Unrealized capital gains: Similar predicament as stock options, but you might have more flexibility in the timing of income.
All of these might cause your taxable income to go up. In turn, this would decrease the amount you can convert in a tax year.
In this regard, we’re talking about your pre-tax accounts (IRAs, 401ks, and deferred compensation plans).
For an account owner, the higher your account balance, the more you’ll expect to convert. And the higher the converted amount, the more conversion taxes you’ll pay.
But there are still ways you can keep your marginal tax rate low. Especially if time is on your side.
Time is a significant consideration in developing a Roth conversion strategy. Someone who has 20 years to do Roth conversions is able to stay at a lower marginal rate than someone who only has 5 years.
For example, someone who achieves financial independence in their fifties might have 15 or more years to fully convert their accounts. Conversely, someone who doesn’t retire until age 70 has to make the most of their opportunity.
The other consideration is tax law changes. The longer the time horizon, the more likely tax laws will change. This adds complexity to your Roth conversion strategy. This might be a good thing if today’s current tax rates go down. But it might have the opposite effect if they go up.
Of course, that depends on your financial goals.
Your goals reflect the things you want to achieve with the financial resources you have. They might include things like:
- Increasing your total net-worth
- Maximizing your retirement savings
- Taking advantage of those tax-free withdrawals from a Roth account
But those are all personal goals. In other words, those goals reflect someone’s personal situation.
Sometimes, financial goals extend beyond oneself. For example, some people might want to pay the taxes on their Roth conversions so their IRA beneficiaries don’t have to.
Other people have charitable intent and want their IRAs to go to charity after they pass. In those cases, Roth conversions are an unnecessary waste of tax dollars.
Tax Planning Opportunities
Your tax planning opportunities might not drive your decisions. In fact, they shouldn’t force you into an imprudent decision. But they might influence how those decisions are implemented.
Of course, those tax planning opportunities might be different based upon your situation.
For example, let’s look at two couples who are both charitably inclined.
- Couple A has a lot of money in retirement plans.
- Couple B has a lot of appreciated stock in taxable accounts.
The best tax planning opportunities for Couple A will in fact differ from those of Couple B.
Couple A might focus a little on balancing their charitable intent with their Roth conversions. This might mean actually not converting everything from their traditional IRAs. Instead, they would plan for their eventual RMDs to be distributed as qualified charitable distributions (QCDs). Since QCDs are tax-free, this is a very tax-efficient way of supporting their favorite charities.
Conversely, Couple B might best benefit by donating their appreciated stock. They could do this either directly to the charity or through a donor-advised fund. They could then deduct their charitable contributions on Schedule A of their tax return.
Each family situation is different, and has different tax planning opportunities. The challenge is finding the opportunities that apply to your situation. From there, you can create a plan to achieve the lowest possible tax rates for you.
What’s the way forward?
Striving towards the lowest possible practical tax bracket for your situation.
This is where the rubber meets the road. Once you’ve laid out all the facts, you start trying to put the pieces together for your Roth conversion strategy. You should have enough information to actually do this.
But if you can’t do it yourself, that’s where your tax-focused financial advisor comes in. As IRS rules become more complicated, many financial advisors are responding to clients who want taxes as part of their financial planning.
Most financial advisors don’t give tax advice. Tax advice should only come from a tax professional, like a CPA or enrolled agent.
However, financial advisors can help their clients with tax planning. Tax planning is simply looking for ways to reduce the tax implications of your financial decisions. This is also known as tax-efficiency.
You can incorporate tax-efficiency into such decisions as:
- Selecting the right investment products for your portfolio
- How to make the right investment decisions in your retirement accounts
- How to do a qualified rollover from your workplace retirement plan
A tax-focused financial planner can help with these decisions. Additionally, they can help you with comprehensive planning to avoid personal finance issues down the road.
Additionally, your financial advisor can help you with the other aspects of financial planning. This might include:
- What is the best investment advice for your financial situation?
- How do I build the right investment portfolio for my goals?
- How do I accumulate enough retirement assets for my future years?
- What retirement costs do I need to be prepared for?
- Do I have beneficiary designations for all of my accounts?
- Do I have the proper estate planning documents in order?
Why can’t I do this myself?
The truth is, you probably can. There are enough interactive calculators and self-help tools out there. Someone who has the time can use these tools to figure out a plan that works for them.
But it doesn’t always work that way. Just because you can do something doesn’t mean:
- That you will do it
- That you will keep on top of it
- That you will do it correctly
Just ask any plumber who’s hired to “repair what your husband fixed.“
Hiring a financial planner will help ensure that you remain committed to your financial plan for the long haul. And good financial planning involves the right balance of paying taxes today so you can take advantage of tax-free income from Roth IRA withdrawals down the road.
Managing your tax bracket just one of the myriad factors that go into creating and executing your Roth conversion strategy. If you don’t feel comfortable doing this yourself, you should talk with your tax professional or financial advisor.