Tax planning is a crucial aspect of financial planning, and the current low federal tax rates provide an opportunity to consider converting traditional IRAs to Roth IRAs. In this blog post, we will be discussing the five effects of a Roth conversion, a tax planning strategy that can help pre-retirees or baby boomers optimize their retirement plan.
With the sunset of tax rates in 2026, it’s important to start considering your long-term retirement plan and how Roth conversion could potentially help you avoid unnecessary tax increases. We will dive into each effect and discuss the pros and cons of implementing this strategy, including paying tax now instead of later, using taxable dollars to buy more Roth dollars, and smaller required minimum distributions.
So, if you are curious about Roth conversion and how it could benefit your retirement plan, keep reading!
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Effect #1: Pay Taxes Now Instead of Later
Most pre-retirees and baby boomers have a substantial portion of their savings in tax-deferred accounts. Converting these traditional IRAs to Roth IRAs requires paying taxes upfront. However, it ensures that the money grows tax-free, and you won’t have to pay taxes on the money when you withdraw it during retirement.
Paying taxes now could be more beneficial for your long-term retirement plan. While it is essential to consider your current average tax rate, it is also important to not make assumptions about future tax rates.
Effect #2: Use Taxable Dollars to Buy More Roth Dollars
Using taxable dollars to pay the taxes on a Roth conversion is another effect of this strategy. Non-retirement account dollars, such as those in bank accounts or non-taxable brokerage accounts, can be used to convert money from tax-deferred to tax-free accounts.
It is crucial to consider the length of time the money will stay in the Roth account and when you plan to spend the dollars. Understanding the rate of return on these assets, interest, dividends, price, and appreciation is also essential.
Effect #3: Smaller Required Minimum Distributions
The Secure Act 2.0 has recently passed, pushing back the age of required minimum distributions (RMDs). Roth conversions can reduce or eliminate RMDs, which are the annual withdrawals required from tax-deferred accounts starting at age 72. Roth conversions can be especially useful for individuals who want to keep their marginal and average tax rates low, even during retirement.
Effect #4: Lower Taxable Income
One of the most significant advantages of converting to a Roth account is the opportunity to pay taxes on retirement savings at current tax rates, which can be lower than future rates.
However, it’s worth noting that the fourth effect of a Roth conversion is that, depending on how taxes are paid, there may be fewer dollars on your balance sheet. This reduction in account size can be advantageous for individuals with estates subject to estate taxes. However, most people will not be significantly affected by this minor shareholder status in their IRA or 401k.
To determine if a Roth conversion is the right strategy for you, it is vital to assess all the potential benefits and drawbacks and collaborate with a financial professional to create a comprehensive tax planning plan that aligns with your long-term goals.
Effect #5: A Potential Legacy Strategy
Finally, the fifth effect involves implementing a solid strategy that takes into account the importance of comprehensive retirement planning and tax planning. Having a tax plan integrated into your retirement plan is crucial since it will determine the amount of taxes you pay.
Those who are proactive and have a clear strategy in place, including understanding the advantages and disadvantages, will be satisfied with their decisions regarding retirement planning. It is important to note that any decision made in this regard will require giving up something.
For instance, if you decide to execute a Roth conversion strategy, you must consider the break-even points, affordability, and timing. This strategy aims to enable you to retain more of your social security checks annually or monthly in the future.
However, you need to bear in mind that the provisional income calculations come into play, and any tax-deferred IRA income taxed at ordinary income tax rates will increase your provisional income, determining the taxable portion of your social security income.
This may prove costly for most pre-retirees since their income sources will comprise social security and traditional IRAs, 401ks, rollover IRAs, or pensions, resulting in higher provisional income and more taxable social security income.
Nevertheless, a benefit of executing a Roth conversion is that, although you may pay more initially, you will keep more of your social security income in the long run, which will reduce your reliance on your nest egg or portfolio. Additionally, you may lower your withdrawal rates from your investments. However, it is vital to understand how this will impact you in the short and long term.
Is a Roth Conversion Strategy Right For You?
Roth conversions can be an excellent tax planning strategy, but they are not suitable for everyone. Before making a Roth conversion, you should consider your unique tax situation, including your current and future tax rates, time horizon, and the impact on your Medicare payments.
It is also essential to have a comprehensive strategy that considers the rate of return on assets, tax costs, and potential benefits of leaving a tax-free inheritance. By understanding these key effects of Roth conversion, investors can make informed decisions to optimize their tax planning strategies.
If you’re looking for an experienced advisor to help you understand your options, MOKAN Wealth Management specializes in helping you create a tax-efficient retirement plan. We can help you turn your stack of statements and diversified pie chart into a tax-efficient retirement plan that helps you keep more of what you’ve worked to save.