As a couple approaches retirement, one goal should be to implement a tax optimization strategy to help ensure your portfolio reaches its maximum potential and, hopefully, leave something behind for your beneficiaries.
One great strategy is to convert your current 401(K) or IRA to a Roth 401(K) or Roth IRA. If you’re unsure of what a Roth is, it is a post-tax retirement account that lets your funds grow tax-free over your lifetime. Taxes are paid on the funds you put into a Roth right away, unlike the tax-deferred funds you put into a traditional retirement plan.
When does it make sense to convert?
When markets are low
- If the markets drop, say, as they did in 2008, you are presented with a golden opportunity to pay taxes on a much smaller sum than you would during market highs. It may be the single most significant factor when confronted with the question of whether to convert or not.
- The younger you are, the more it makes sense to convert. You will have a lot more time to ‘break even’ plus a significant number of years to let those funds grow tax-free. A sizeable tax-free account takes the guessing game out of how much you can pull each month, as you won’t need to calculate taxes from each withdrawal.
You believe you will be in a higher tax bracket in the future
- It may be difficult to assess, as we have no idea how future tax brackets will look. But, one thing to consider is that taxes are historically low, and once the Trump-era TCJA tax cuts expire in 2025, we can all expect a tax bump in 2026.
You have fewer sources of income (or less income)
- Tacking onto those mentioned above – perhaps you are already retired but are not taking Social Security payments yet, or are not taking advantage of other retirement income streams. Or maybe you are in-between jobs or on a sabbatical. While you have fewer sources of income, it may make sense to pay taxes now since you will most likely be in a lower tax bracket.
You want to leave a tax-free gift
- Any beneficiaries of your Roth IRA will not have to pay taxes on any withdrawals, though they must start receiving distributions at age 72.
When does it NOT make sense to convert?
You believe you will be in a LOWER tax bracket in the future.
- As always, it’s difficult to predict what tax bracket you will be in. With that said, a custom retirement plan gives you a better idea if you will earn more or less money in the future.
You need the tax deductions
- If you rely on tax deductions to help move your taxable income into a lower tax bracket, a Roth conversion may not be suitable for you. The conversion results in a higher taxable income, therefore potentially pushing you into a higher tax bracket.
You need the funds soon.
- There is a five-year hold on all funds converted to Roth, regardless of age. If you decide to withdraw within five years, you will be subject to a 10% early-withdrawal penalty.
You don’t have cash on hand to pay the taxes
- When you convert to Roth, you must pay taxes on those converted funds. If you don’t have money in a traditional savings account or elsewhere, you will have to take an early withdrawal that will be subject to a 10% penalty.
Converting pushes you into a higher tax bracket for the year.
- Conversions count as taxable income, and converting too much can bump you up a tax bracket. A financial planner would consider this and determine how much you can change without getting moved up.
The above reasons to convert to a Roth are all great, but it takes a skilled financial planner to get them all right. At different stages of your life, you will want different investment strategies to reduce your overall tax obligations. Plans should include a careful mix of Roth and Traditional accounts, each with appropriate asset allocations for risk and tax optimization.
A general rule of thumb is to use your taxable retirement accounts first upon retirement, letting your Roth accounts grow tax-free. As there is no required distribution age with a Roth, you can let these accounts grow as long as you wish – and you can even keep putting into them. Additionally, you can always take out contributions – but not their earnings – without fear of taxation or penalty for those moments when you are cash-strapped.
Location arbitrage is another crucial strategy for retirement, and Florida is a great example. Since there is no state income tax, your traditional IRA withdrawals will not be double taxed, thus saving you considerable money.