If you’ve followed me for any length of time, you know that the best thing I believe most people can do for their future retirement is to do a Roth conversion and do it sooner than later. The main reason I like Roth conversions so much is because we’re in a period of time where we have historically low tax rates. They’re have only been four other periods since taxes were imposed in 1913, that the highest marginal tax bracket has been lower than it is today.
And the last time the highest marginal tax bracket was significantly lower than it is today, was clear back in the early 1990s. Okay, for some of you, that might not seem like that long ago. But I have six children, and not one of them was even born in the early 90s. In fact, I wasn’t even married back in the early 90s. For me, it does seem like a long time ago.
You may be saying to yourself, this is great: We have historically low tax rates. But what does that have to do with my Roth conversion? And the answer is everything. If the tax rate you will be required to pay in the future is even 1% higher than the tax rate you’re currently paying, you will save money by doing a Roth conversion.
Unfortunately, many people get the math messed up here, and they think that they have less money to invest because they had to use some of the money to pay the taxes. But no matter what tax rates are, they will come out ahead by keeping their money in traditional tax deferred retirement accounts. However, this is just not true.
In fact, let me take you through a quick little exercise to prove my point. Let’s assume your tax rate is 30%. And you have $200. You decide to take $100 of this money and invest it in a traditional tax deferred retirement account. You then decide to take the other $100 and pay the 30% tax and invest the remaining 70% in a Roth retirement account.
Now, let’s assume you had amazing growth in both of these accounts. And a year later, the amount you’d invested in each of these accounts has doubled. Your traditional retirement account now has $200, and your Roth account now has $140. But remember, you’ve not yet paid the taxes on the $200.
So let’s go ahead and pay those taxes now. When you do that, you find the taxes on $200 at 30% is $60. You subtract that amount from 200. What do you have in your account? What you have left is $140. Yes, the exact same amount you have in your Roth account. But what if taxes wind up 10%, would a traditional tax deferred account be the best way to go? If taxes go up to 40%, and you apply the increased tax rate to your $200 traditional retirement account, you now owe $80—in tax. This leaves you with only $120. But wait, your Roth still has $140 because you chose to pay those historically low tax rates—yes, prosperity nation, if you believe your tax rate will even be 1% higher in the future.
Now is the time to take tax risk off the table and do a Roth conversion. In most of my presentations, I only focus on federal tax risk and why taxes will have to go up in order for the US government to have the money they need to cover unfunded liabilities, such as Social Security, Medicare and the national debt. But I think we must start taking a much closer look at state and local governments than we have in the past.
There are many states that are currently experiencing some major budget shortfalls. For many of them, increasing taxes will need to be a part of their overall plan to get out of the situations they’re currently in.
Now, I think I made a pretty good case that future tax rate should be your main reason for considering a Roth conversion for you and your family, but tax rates are not the only thing you should be looking at. There are five other aspects you need to take into consideration as you look at doing your own Roth conversion.
Number one: Consider where you want to live in retirement. As I just mentioned, state taxes are becoming a much bigger issue when we look at our overall tax risk. If you’re currently living in a no income tax state such as Nevada with the plan to move into a high-income tax state such as California, it’s very important to take this into consideration as you look at the timing of your own Roth conversion.
But what if you’re going to be moving from California once you retire to Nevada? This also needs to be taken into consideration. Either way, the most important takeaway is we’re in a period of time where we have historically low tax rates, and we need to look to see if we can take advantage of these low rates—no matter where we live.
Number two: You need to consider your beneficiaries. One of the benefits of a Roth IRA is that it isn’t subject to required minimum distributions at age 72. Meanwhile, traditional IRAs require you to withdraw an IRS mandated amount each year starting at that age, and every dollar you pull out is subject to income tax. Because Roth IRAs aren’t subject to required minimum distributions, they can continue to grow tax free for as long as you live. And if your beneficiary is your spouse, he or she can roll over the account and make the Roth IRA his or hers, and the same rules will apply.
Now for non-spouse beneficiaries, they will be subject to a required minimum distribution, but that distribution won’t be taxed, which can be a huge benefit, especially since what we’ve found is that most people receive retirement accounts from a deceased parent receive them during a time that their taxes are the highest because they’re in their prime working years.
Number three: consider the emotional price tag of converting to an IRA in order to get tax free benefits for life from a Roth account There’s a cost of entry, and that cost is taxes. What I’ve found over the years of working with people regarding Roth conversions is that this tax bill seems to be their biggest hang up. The tax is being paid in larger sums than it would have been had they been paying a little bit each year. It seems as if they’re watching all their hard work of saving for retirement quickly disappear. But this isn’t what’s happening at all.
What they’re actually doing is planting a seed that’s going to allow them to reap lifetime tax free benefits. They no longer have to worry about what tax rates are going to be in the future. Plus, they can cut out their Silent Partner, which is the federal, state, and local governments. This will allow the retiree to set themselves on a path to a more secure retirement.
Number four: You need to take into consideration things such as college financial aid, or other government benefits. When you do a Roth conversion, all amounts converted are going to be reported on your tax return as taxable income. When this happens, it’s going to increase your adjusted gross income, which also means you may no longer qualify for various forms of government assistance you might have been receiving benefits from or counting on. If you have benefits you believe may be affected by doing a Roth conversion, make sure you disclose this information to your advisor, so they can calculate the consequences of losing these benefits into your overall plan.
Number five: You need to consider the sequence of return risk and what a stock market decline can do to your tax outlay following your conversion. Sequence of return risk is the risk that the stock market is going to decline at a time. That is not beneficial to your overall retirement plan.
Let’s assume that you decided to do your Roth conversion at the end of 2019. When the stock market was at an all-time high, you decided to roll over $100,000 and ended up paying tax at 30%. This means you ended up paying total taxes of $30,000. Then let’s fast forward to the end of March 2020, when the stock market was down between 20 and 30%. Now your $100,000 is only worth between 70 and $80,000. What if you were to do a Roth conversion then, instead of paying $30,000 in taxes? You would have only owed between $21,020 4000 if you’re in a down market. A Roth conversion should definitely be considered, but we can’t determine what the stock market’s going to do in the future.
Even though we expect the stock market to only go up over the long term, this doesn’t mean we should keep waiting for a down market and let these historically low tax rates pass us by because if the conversion is not done and your investments never go down, you will have a major problem in the future when tax rates go up and you have to pay the tax.
This is one of the reasons I promote doing Roth conversions over a period of time, somewhere between 5 and 10 years, because it works kind of like dollar cost averaging, but only for your taxes. What’s the long and short of all this is that we have historically low tax rates. We know the exact date taxes are scheduled to go up, which is January 1, 2026. We know that depending on the administration, this date could change, but it will only change for the worse because it means tax rates will go up sooner and faster.
We know taxes are not the only issue we need to consider when looking into a Roth conversion. This all means it’s time to take action and determine if a Roth conversion is right for you, and can be a critical part of a tax free and risk free retirement plan. Time is running out to get the best benefits of doing your conversion. And I would hate for any of you to have to look back, saying I had the opportunity to do a conversion, and now I wish I would have taken action when I was told about doing it.