A Roth Conversion: Pay Uncle Sam now or pay him later

Certainly the usual rule for most of us is to “delay paying taxes as long as possible.” However, I would argue that this is the month that many investors should consider violating that rule so that they can lock in tax-free growth forever.

If you have a traditional IRA, you are eligible, regardless of age or income, to convert all or part of it to a new or existing Roth-IRA investment(s) that grow(s) without ever owing Uncle Sam another dime. The downside is, of course, that you must pay normal federal and state income taxes next year on all the money you move from a traditional IRA to a Roth this year.

Your first consideration, if you have the cash to pay the extra taxes, is typically to figure out how much you can convert without moving into a higher tax bracket. The problem is that computation must be done this month, before year-end, when many taxpayers only have a vague estimate of this year’s tax liabilities.

We believe that if you can stay in the 15 percent federal tax bracket — $74,900 or under taxable income for couples ($37,450 for singles) — it makes sense to convert if you have the money to pay the extra taxes. We believe paying about $1 in taxes for every $5 converted (5.75 percent is the N.C. rate) is a great trade-off.

index(A simple example would be that you and your spouse believe your taxable income — after all deductions — will be about $60,000 this year. Then you decide to convert $12,000, leaving $2,900 as a cushion against an estimate that may be too low. You then would owe an extra $2,490 in taxes — $1,800 in federal taxes and an additional $690 for N.C. The payoff, of course, is that $12,000 can grow without Uncle Sam waiting to get part of it; you can spend it all tax-free after age 59½ or leave it to an heir without any taxes due.

One problem for lower-income seniors is that a Roth conversion may boost their tax rate on Social Security income. If their overall income (adjusted gross income plus 50 percent of their Social Security payment plus tax-exempt interest) is under $25,000 for singles, or less than $32,000 for couples, Social Security payments are not taxable.

Couples who make between $32,000 and $44,000 and singles with income from $25,000 to $34,000 pay taxes on up to 50 percent of their Social Security payments. Higher-income couples making $44,000 or more and singles who earn $32,000 or higher must pay taxes on up to 85 percent of their benefits.

For taxpayers who are in the 25 percent middle-income bracket — $74,901 to $151,200 for couples and for singles $37,451 to $90,750 — conversion costs them 30.75 percent in combined federal and state taxes. (Typically, I don’t recommend conversions for taxpayers in the four highest federal tax brackets: 28 percent, 33 percent, 35 percent, and 39.6 percent, but there are some exceptions.)

  1. If you are in that 25 percent federal tax bracket (or higher) consider the following questions. If you can answer yes to most of them you may want to consider a Roth conversion.
  2. Will I remain in the same tax bracket after I do the conversion?
  3. Will I be in the same or higher tax bracket when I’m ready to use the money after age 59½?
  4. If eligible, am I investing $5,500 for under 50 or $6,500 for age 50 and over in a Roth-IRA each year?
  5. Am I already maxing out my tax shelters at work — the 401(k) and 403(b) max for this year and next is $18,000 for under 50 and $24,000 for age 50 and over?
  6. Am I taking advantage of the Roth pension option at work if available? (It is choosing the Roth tax-free option over the traditional tax-deferred plan.)
  7. Do I believe that Congress is so inept it will never agree to overhaul our current tax system to provide lower tax rates with fewer exemptions?

A strategy that my son, Steve Hungerford, often recommends for retired seniors in their 60s, who have significant savings, is to postpone taking Social Security payouts until age 70 to earn an 8 percent bonus every year they delay. As a result, they may be in the 10 percent (taxable income of $18,475 or below for couples and $9,225 or less for singles) or even the zero percent tax bracket if their income is lower than their exemptions. Obviously, they should convert every year until their income goes way up when they start drawing Social Security and are forced to take required minimum distributions from traditional IRAs at age 70½.

If you do a Roth conversion, consider transferring your highest-risk stock or mutual fund. If it goes down, you have until Oct. 15 next year to do a no-penalty (no taxes due) cancellation of that conversion — called a “recharacterization” by the IRS. Obviously, if your aggressive investment goes up, you keep it and pay the taxes on the conversion price. What a deal from the usual not-so-friendly IRS: “Heads you win and tails you break even!”

Please call us at 998-7000 if you would like free advice about whether a Roth conversion makes sense for you this year.

 

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