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Six Reasons You Might Want to Do Roth Conversions

Over dinner friends of yours mention how they’ve recently started taking the money in their traditional IRA and moving or “converting” it into a Roth IRA. They talk about how this is going to help them down the road. By paying taxes on that money now, they won’t owe any taxes in retirement.

Suddenly, you’re wondering, “Should we be doing that too? When does it make sense to do Roth conversions?” 

In this video and blog post, we’re going to give you six reasons you might want to begin doing Roth conversions right now

1. You could be in a higher tax bracket in retirement.  

Most federal employees find their income goes down a bit when they retire. Most of the time, they’re still in the same tax bracket—either at the top of the 22% bracket or the bottom of the 24% bracket. When they retire, perhaps they find themselves in the middle of the 22% bracket.

But that isn’t always the case. Some retirees actually see a bump in income. And that can be a problem. It can propel them into a higher tax bracket.

There’s a related question “Could taxes simply be higher in retirement—for everyone?” If that were the case, you’d be paying more in taxes even if you remained in the same bracket. When Congress changes all the brackets for the worse, taxes are worse. 

Bottom-line, if you think your taxes might be higher in retirement, then contributing to Roth, and doing Roth conversions before that day comes, may be wise. 

The idea is to pay taxes when tax rates will be the lowest for you. If you feel your tax rates will be higher in the future, then a Roth conversion makes sense.

A second reason you might want to consider doing Roth conversions now is… 

2. Roth IRAs have no required minimum distributions.  

A required minimum distribution (RMD) is when the IRS makes you take money from your traditional account—whether it’s a traditional IRA or a traditional TSP. (FYI, the government has recently changed the rules so that the mandatory age is 73. For younger folks, it’s going to be 75.) 

The IRS is serious about you taking RMDs. In fact, there’s a 25% penalty when you don’t take them. (Why are they insistent on this? Because they know that when you do, they’ll get to collect taxes on those distributions.)

However, penalties aren’t the only problem. The bigger problem is being forced to withdraw money you don’t want to withdraw. Many federal employees are living just fine off their pension and their Social Security—and maybe a spouse’s Social Security too. They don’t need to take big distributions from their TSP or their IRAs. 

In fact, some of the people we work with don’t need to take distributions at all. But when they hit the age 73 or age 75, the IRS requires them to take some of their money out. And again, when you take traditional money out, it’s taxable at whatever tax bracket you’re in. 

Sometimes these required minimum distributions can be so large they bump you up into a higher tax bracket! (Now, we’re back to the first reason for wanting to do Roth, which is avoiding higher taxes.)

The great thing about Roth IRAs is that there are no required minimum distributions. The government doesn’t make you take any money out. You can keep the money in your account where it keeps growing (hopefully)…all with tax free status. This is another great reason to do Roth conversions pre-retirement. 

Here’s a third…

3. Tax diversification 

When many federal employees get ready to retire, the vast majority of their money is in a traditional TSP, meaning it’s going to be fully taxable whenever they withdraw the money. 

Now, everybody is aware of diversification—the strategy of not “having all your eggs in one basket.” When many think of their TSP funds, they assume “I’ve got some money in the L fund, some in the G fund, some in the C fund, and maybe some of the I fund. I’m diversified!” 

But what about tax diversification? 

Holding all of your money under one taxable status can lead to problems. If taxes go up, you can be left holding the bag. If you must take withdrawals, and those distributions all come from taxable sources, that’s what you got to do. 

Now, hopefully later in life, you’re going to get to take some large distributions for something fun. Maybe you’re going to get a boat, or take an around-the-world vacation, maybe buy an RV. 

Or, maybe, you’ll have to take some large distributions for something that’s not fun—like long-term care or medical expenses. The problem, again, is having to take large withdrawals from taxable sources. If that’s your situation, those distributions can send you way up the tax bracket. 

However, if you had moved your assets into a Roth IRA or Roth TSP, you’d have a tax-free place where you could get needed funds. And if you needed to take a large distribution, you could do that without any tax worries.

Again, you only get to do this if you’ve diversified your money, tax wise. 

There’s a fourth reason to convert to Roth …

4. Estate planning 

People talk about how a traditional TSP or IRA lets you postpone paying taxes. And that’s true. But if you—let me rephrase that—when you die, the money in that traditional TSP or IRA is going to be left to your beneficiaries. And they will be required to pay taxes on that money. 

Roth IRAs, by contrast, are not taxable to your heirs. Let me repeat that: They’re not only tax-free to you in retirement, they’re tax-free to your beneficiaries!

The Secure Act 2.0 recently changed the rules here. Currently, heirs have only 10 years to take distributions from an inherited IRA. (A spouse actually has a few more options, but non-spouse beneficiaries—think “children”—have just 10 years to withdraw that money.)

Leaving somebody traditional money where they have only a limited window of time to access it can cause a tax burden for them.

On the other hand, if you left them a Roth IRA, they’d still have only a 10-year window to withdraw those funds. However, when they withdrew the money, it would not be taxable to them. Because of that, they might wish to leave the money there for 10 full years to let it keep growing tax free. In year 10, they could take a full distribution, maximizing the “tax freeness” of the money. 

In short, Roth IRAs are very beneficial tax-wise when leaving money to your beneficiaries. 

A fifth reason that converting to Roth might be wise is if you anticipate…

5. A change in your tax filing status.  

Many of the people we work with are married couples getting ready to retire where one is a federal employee. One scenario we see fairly often is that when one spouse dies, the remaining spouse suddenly finds himself or herself in the single tax bracket. 

Why is that a problem? Because the single tax bracket is not nearly as generous as the married filing jointly bracket. Practically, this means if you leave traditional money to your spouse, RMDs will force them to pull those funds out. And because they are in the “less generous” single tax bracket, it can increase the amount they owe in taxes.

Doing Roth conversions—i.e., making sure your money is tax diversified (see #3 above)—means that if one spouse dies, the remaining spouse can take tax-free distributions. Even though they’ll be in the single tax bracket, it won’t affect them as much because the money coming to them will be tax free. 

Whether through death or divorce, it’s possible to find yourself in the single tax bracket later at some point. Taking advantage now of your married filing status can be wise. 

A final reason to do Roth conversions is to capitalize on times when…

6. The stock market is down.  

Markets go down and markets go up. If you do Roth conversions when the market is down—effectively moving your money to Roth at a discounted rate, and then having that money in your Roth account when the market bounces back, can be advantageous. 

The fact that stock prices have gone down allows you to Roth convert more shares at a lower price. That sets you up to hopefully have an even larger potential gain later when it bounces back. And since it’s all in the Roth account, those gains are tax free. 

When we work with clients, we get a copy of their tax return to help determine how much they need to convert to Roth in this calendar year. One of the things we’re looking for at that time is how the stock market is doing.

We prefer to do Roth conversions when the market is down. Of course, some years you get all the way to November and the stock market never did go down! In years like that, you just have to go ahead and Roth convert at whatever the going stock market rate is. 

Remember during the COVID pandemic when the stock market dropped significantly? That was a prime opportunity for many of our clients to take advantage of Roth conversions. Later, when the market bounced back, it was great from a tax standpoint for our clients.

With Roth conversions we’re trying to maximize your tax bracket status and thereby minimize your taxes. We cover that topic in greater detail in this video right here (no additional video cited in Mel’s video). We discuss tax brackets in 2023. Did they just get lower? If they did, it means it’s even better to have a Roth conversion strategy. 

If you have questions about any of this or would like to discuss creating a Roth conversion strategy for your traditional funds, we’d love to help. In the upper right-hand corner, click the green button that says “TALK WITH AN ADVISOR.” We’ll be in touch right away! 

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