Converting Roth IRAs For Tax DiversificationFebruary 25th, 2020 by Jim Allen
Tax diversification is an important part of any financial plan and the Roth IRA is great way to diversify the tax treatment of your investments. Unlike the traditional IRA where you normally get a tax-deduction for the contribution, Roth IRA contributions are made with after-tax money. But, when qualified distributions are made from a Roth IRA, they are income tax free. Whereas traditional IRAs don’t tax the contribution but do tax the distribution (not taxing the seed but taxing the fruit), Roth IRAs tax the seed but not the fruit. Since nobody truly knows what tax brackets will be in the future, it is smart planning to have some funds in both types of accounts. The trick however is to get funds into a Roth IRA and that is where conversions come in.
A Roth conversion entails taking part of your traditional IRA and converting it to a Roth IRA. This means that you will pay tax on the conversion. However, it also means that if distributions from the Roth are made after 5 years and age 59 ½, they will be income tax free. The strategy with a Roth IRA conversion is to convert just enough so that you stay in the same tax bracket – which requires careful planning and some income tax projections. It generally does not make sense to do such a large Roth IRA conversion that you are thrown into a higher tax bracket.
For example, say you are a married couple filing jointly and your 2019 taxable income is $65,000. This places you in the 12% tax bracket. The top of the 12% bracket is $79,000 so we could convert $14,000 from a traditional IRA to a Roth and keep you in the 12% bracket. However, if we converted $20,000, we have now made $6,000 subject to the next tax bracket which is 22%. So, in general, we will only look to do Roth conversions up to the top of your same tax bracket.
Another opportunity to do Roth conversions is when you have large investment losses, medical expenses or a charitable deduction that we can use to offset the taxable income from the Roth conversion. Say you had a major health event and have large medical expenses that can be itemized. In that year, we can take advantage of the medical expense deduction to increase the amount of a potential Roth conversion.
Doing conversions to a Roth IRA may not always make sense, but we continuously evaluate the opportunity as part of our process.