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Should I Be Doing a Roth Conversion?

One strategy we, and our fellow fee-only financial planner friends, have been discussing a lot lately is Roth conversions.  This year in particular we witnessed (and conducted one for ourselves!) a lot more Roth conversions than usual.  It’s a strategy we have been recommending and processing for our clients due to two big reasons: tax savings and market suppression.  In this week's blog, we lay out what the strategy is, how to do it, and if it makes sense for you!

What is a Roth conversion?

A Roth conversion is moving funds from your Traditional IRA (or 401(k), 403(b), etc.) to your Roth IRA (or Roth 401(k), Roth 403(b), etc.).  You are simply converting funds from tax deferred dollars (like Traditional IRA funds) to post tax dollars (like Roth IRA funds).  

Who can make a Roth conversion?

Unlike Roth contributions, Roth conversions can be done by almost anybody!  There are no income restrictions with Roth conversions.  There are rules and items to consider if you are 72 or older (RMD age), and if you have non-deductible IRA dollars.  However, for the most part… you are likely eligible to do this!  

How do you conduct a Roth conversion?

This will depend on what account you want to convert (Traditional IRA or Employer Provided Plan like your 401(k) or 403(b)).  If you have a Traditional IRA at a custodian (a custodian is a fancy word for the company that holds your investments and/or retirement account), you can simply pick up the phone and give them a call with your instructions.  Some custodians allow you to process the conversion online, too!  If you want to conduct a conversion with your Employer Sponsored Plan, this may be a little bit more complicated.  Your plan may allow you to conduct an “in-service” (meaning you still work for the company) conversion.  With an in-service conversion, you are taking your pre-tax 401(k) dollars and moving them to Roth 401(k) dollars.  That’s the easiest and most ideal route.  If your plan does not provide that option, you would need to see if the plan allows for an in-service distribution to a Traditional IRA.  If so, you can convert the dollars from the newly established Traditional IRA to a Roth IRA.  If your plan does not allow for any in-service distributions or transfer, then you may be S.O.L. for these dollars!  Connect with us to help determine what options are available to you.

What are the tax implications of a Roth conversion?

Like I stated before, a Roth conversion is the act of transferring dollars from a tax-deferred asset (like a Traditional IRA) to a Roth IRA.  Now, let's think about how those dollars first got into the Traditional IRA to begin with.  You haven’t paid taxes on those dollars in the account because you deferred the taxes until you take a distribution.  When you make contributions into a Roth IRA, you pay taxes on the dollars going into the account.  Therefore, when you transfer dollars from the Traditional IRA to the Roth IRA, you need to pay taxes on the amount you are converting.  You have two options for this:

  1. Pay the taxes on the transfer.  Some custodians require, or allow, you to withhold taxes on the distribution.  If you planned on transferring $50,000 to a Roth IRA, you may elect to withhold 10% for federal taxes and 5% for state taxes.  After taxes are withheld, the transferred amount going into the Roth IRA will be $42,500.  HOWEVER - you may be subject to a 10% penalty on the taxes withheld if the IRS determines that amount withheld was an early distribution, and therefore you must pay the early distribution penalty.
  2. Pay the taxes when you file your taxes next.  If the custodian allows you to make the conversion without paying taxes up front, you can defer the tax payment for when you file your taxes.  In the same example above, you would have the full $50,000 go from the Traditional IRA to the Roth IRA.  Then, when you file your taxes, you would have to come up with the tax implications from the transfer.  Let’s say you did the conversion today, you would have until April 15, 2021 to save and pay the taxes incurred from your conversion.

Why would I do a Roth conversion?

Converting when you’re in a lower tax bracket:  The number one reason to process a Roth conversion is because you anticipate being in a lower tax bracket today than in retirement.  Below, I have posted the 2020 Tax Brackets.  Take a look at where you fall.  Do you anticipate your income will increase in retirement?  ...wait, you don’t know??  How do you not know!?!  Just kidding… these things can be hard to predict.  But, maybe this year you happen to get unemployed or furloughed, and your income is predictably lower.  O, that’s 26 million of you and counting?  Keep reading!

Read our recent blog: I’m Furloughed, Now What?


2020 Tax Brackets 4.27.2020 Blog.JPG

There is also the question on whether or not tax rates will change in retirement.  If you take a look at tax rates historically, we are near all time lows (see Top Federal Tax Rates graph).  I tend to not be a doomsayer, but someones gotta pay that $2 trillion COVID-19 bill (aka WWIII)?  #amirite?  We found ourselves at peak tax rates post WWI and WWII.  How do you think Congress will pay back these stimulus packages?  My guess is it won’t be through Etsy accounts and side hustles...  


original source found here
 original source found here                                

Converting when the market is down:  The S&P 500 (a measure of large US company stocks) has yet to recover from it’s high on February 19, 2020.  As of this riding, the ‘bottom’ of the COVID-19 bear market was March 23, 2020.  We may not reach that bottom ever again, or we may drop even further.  What does that all mean for you?  The market is down right now regardless of what direction it decides to go tomorrow.  This means it has the potential to grow significantly between now and when it surpasses it’s February 19th high.  This can be a very good time to conduct a Roth conversion.  Follow the example below for further clarification:

You have $100,000 in a Traditional IRA on February 19th.

On this day, you had one stock in the IRA valued at $20/share.

Your total share count was 5,000 (5,000 shares x $20/share = $100,000 Traditional IRA).

Now your account is worth 15% less than what it was on February 19th.

Instead of your stock being worth $20/share, it’s worth $17 dollars a share.

You still own 5,000 shares though.  Now your total IRA balance is $85,000 (5,000 shares x $17/share).

If you conduct a Roth conversion now, you will only have to pay taxes on $85,000 versus $100,000, even though you still own the same exact amount of shares.  When the market does recover, that $15,000 of ‘recovery’ will grow tax free in the Roth IRA!  Taaa daaa!!  Pretty snazzy, huh?

How do I know how much to convert?

This is where we come in (and your accountant)!  This is the exact question we are answering for our clients (and ourselves!).  From a high level, you want to ‘fill up’ your tax bracket.  You likely don’t want the conversion to bump you into the next highest tax bracket.  For example, if your married and your combined taxable income for 2020 is likely to be $60,000 (this is your taxable income, not your GROSS income), then you have about $20,000 worth of the 12% tax bracket to ‘fill up’ (the 12% tax bracket for Married Filing Jointly is $19,751 to $80,250).  

Reach out to Us

Roth conversions are not for everyone, but they do make sense for a lot more people this year due to your lower tax bracket and the recent market decline).  Contact us today to see if this strategy is right for you!

- Natalie

Disclaimer:  This article is for informational purposes only and is not a recommendation of Fyooz Financial Planning, Natalie Slagle CFP®, or Daniel Slagle CFP®. Past performance may not be indicative of future results and may have been impacted by events and economic conditions that will not prevail in the future. Therefore, it should not be assumed that future performance of any specific security, investment product or investment strategy referenced in the article, either directly or indirectly, will be profitable or equal to the corresponding indicated performance level(s). No portion of the article shall be construed as a solicitation to buy or sell any specific security or investment product or to engage in any particular investment or financial planning strategy. Any reference to a market index is included for illustrative purposes only, as it is not possible to directly invest in an index. Indices are unmanaged, hypothetical vehicles that serve as market indicators and do not account for the deduction of management fees or transaction costs generally associated with investable products, which otherwise have the effect of reducing the performance of an actual investment portfolio.

Natalie Slagle
Founder, Fyooz Financial

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