Is the honeymoon over for the historically low tax rates? A lot of us are asking this question. President Biden is proposing higher taxes to pay for new and expanded government programs. We can discuss if these programs are good or not, but we won’t be doing that here! Nonetheless, there are serious discussions about taxes increasing in various parts of the US population by our government leaders.
So, what does raising taxes have to do with considering a conversion of tax-deferred money (like Traditional IRA’s) into a Roth account? Let’s get some basics out of the way first.
Tax-deferred money (401K, Traditional IRAs, SEP-IRAs, Deferred Annuities) are investment vehicles that are funded typically out of our paycheck BEFORE taxes were paid, and then allowed to grow over time. After 59 ½, we can withdraw this money without penalty, but we do have to pay income taxes on the withdrawals. The general idea is that we can postpone paying taxes on these savings during our working years and then withdraw money during retirement when we are not drawing a paycheck and then theoretically pay fewer taxes on that money. Also, the government makes us start withdrawing money every year from these accounts starting at age 72, being forced to pay taxes along the way. (Required Minimum Withdrawals or RMDs)
Tax-advantaged money (Roth IRAs, Roth 401ks, etc.) is money that was taxed before it was placed into the account, then allowed to grow without ever needing to pay taxes on it again. Even better, there are no RMDs for Roth accounts.
Even if the tax rates do not go up from here, there are plenty of scenarios where after we turn 59 ½, that methodically moving money from the tax-deferred account to a Roth can save us both taxes paid to the government AND can result in more money in our accounts in our later years. Heirs do not have to pay taxes on inherited Roth money either, where that is not the case generally for inherited IRA money. If tax rates are going to go up later this year or January 1 of next year, the case for converting gets even stronger. Let’s look at a couple of examples:
Example 1: Joe is 62 and married. He has a total portfolio of $2.1Mil, and $1.8Mil of this is in tax-deferred money due to his long-term contributions to a 401K. He since left that job and started a new one; allowing him to convert that 401K money to a Traditional IRA, giving him more control and options. Joe is in good health and plans to work until his full retirement age to start his Social Security at 67. He is making $95K per year and lives without any unusual amounts of debt. For 6 consecutive years starting at 62, he moves $200K per year from his Traditional IRA into a Roth IRA. The result:
At age 90, he saves $1.9M in federal taxes paid and increases what his heirs inherit by $119K (versus not converting). At age 80, he saves $1.3M in federal taxes and has $480K more in tax-free money versus not converting any deferred money.
Example 2: Nancy is 73 and married. She has a total portfolio of $3.1M, and $2.5M of this is in tax-deferred money. She retired 8 years ago and lives on $70K per year after taxes. She is in good health and started Social Security at 65 for $1800/month. For 5 consecutive years starting at 73, she moves $400K per year from her Traditional IRA into a Roth IRA. The result:
At age 90, she saves $1.1M in federal taxes paid and increases what her heirs inherit by $190K. At age 80, she saves $690K in federal taxes and has $450K more in tax-free money versus not converting any deferred money.
Why? There are several reasons, but in both examples, the RMDs are generating more tax revenue for Uncle Sam versus converting to a Roth IRA and paying the taxes earlier in their lifetimes, but not for as long because of the conversions. Remember that once converted, Roth IRAs grow tax-free and are inherited tax-free.
Note that these examples were calculated with TODAY’s tax rates. If tax rates increase, these numbers only look more attractive.
Your situation may not be as clear-cut as this. If you’d like this analysis done for you or have questions, please feel free to reach out. I’d be happy to discuss.