Roth IRA’s are a powerful retirement savings vehicle. When you contribute money to a Roth you don’t receive a tax deduction, however any growth on those funds and future withdrawals are tax-free. An added benefit to these tax free withdrawals is that they don’t count as income for purposes of determining whether your Social Security benefits will be taxed and whether you will have to pay a surcharge for Medicare. You also are not required to take money out of a Roth IRA at age 70.5, as you are with traditional IRA’s.
One way to quickly get money into a Roth IRA is through a Roth IRA conversion. A Roth conversion is the simple act of converting a portion (or all) of your Traditional IRA into a Roth Account. The “cost” to a conversion is that you have to pay taxes on the amount converted.
Before we look at when someone should convert, it’s first worth understanding how our tax brackets work.
Our tax code is progressive. This means that as you earn income you fill up each tax bracket. In 2017 the first $18,650 in taxable income is taxed at the 10% rate for married couples. Income from $18,651 to $75,900 is taxed at 15%, income above that is taxed at 25%, and so on. The tax rate that your last dollar of income is taxed at is considered your marginal tax bracket.
Jack and Jill have income of $90,000. Their deductions and exemptions total $20,000, leaving them with taxable income of $70,000. When you look at the chart below (courtesy of Oblivious Investor) you can see that $70,000 of taxable income falls in the 15% tax bracket. However this doesn’t mean that all $70,000 is taxed at 15%. Rather the first $18,650 in income is taxed at 10% and the rest of their income above that amount is taxed at 15%. Their marginal tax bracket is 15%.
As you can see from the chart, there is no 0% tax bracket. However, there can be situations in which you can pay $0 in federal taxes. This occurs when your deductions and exemptions equal (or are more than) your taxable income.
Barbara (single) was laid off from her job half way through the 2016. Her income for the year was $15,000. She has deducitons and an exemption that total $15,000. Barbara’s taxable income is $0 and so she wont pay any federal taxes.
In 2017 the standard deduction is $6,350 for singles and $12,700 for married couples. The personal exemption is $4,050. So a single person can have, at a minimum, income of $10,400 that will not be taxed and a couple can have income $20,800 that will not be taxed. If you itemize deducitons that amount is higher. The standard deduction is also higher for people over age 65.
An opportune time to look at Roth Conversions is in years where you have lower income than normal and/or have higher deductions than normal. This can include someone who just retired and doesn’t have much taxable income coming in, or someone that was laid off but expects to go back to a high income in the future, or someone who has large tax deductions because of charitable gifts.
Mark and Teresa are 60 years old and recently retired. They have no taxable income for the year and have enough in savings to live off of. They have itemized deductions of $25,000 and personal exemptions of $8,100, for a total of $33,100.
They run a tax projection with their Financial Planner and see that they can convert $33,100 entirely tax free.
Mark and Teresa also see from the tax projection that in future years, when they start Social Security and begin pulling money from their traditional IRA’s, they will be in the 25% marginal tax bracket.
Mark and Teresa decide that they want to take advantage of the low tax brackets today and so they convert another $18,650 to fill up the 10% tax bracket. They pay $1,865 in tax for that conversion.
In total, Mark and Teresa were able to convert $51,750 to a Roth for just $1,865 in taxes. That is an effective tax rate just 3.6%!
If Mark and Teresa never did these conversions, a future withdrawal of $51,750 from their IRA could cost them as much as $12,937 in taxes ($51,750 x 25% marginal tax bracket). By making Roth conversions at the right time Mark and Teresa were able to save a substantial amount of money in taxes.
Mark and Teresa may also want to look at filling up the 15% tax bracket with conversions this year as well.
I simplified this example in order to help make the important points clear. But with that said, the example isn’t unrealistic. We often see situations similar to Mark and Theresa’s, even though the tax situation may not be as simple and clean. If planned for properly, a Roth conversion can help you save in taxes and in turn help your bottom line throughout retirement.