As well-known retirement income planning experts, Ed Slott and Jeff Levine get a lot of questions about the mechanics of Roth conversions and related strategies that can support a tax-optimized approach to retirement.
One question that both regularly get from advisors is whether it ever makes sense to have clients in the 37% maximum income tax bracket for a year to convert funds held in a traditional pre-tax individual retirement account to a Roth IRA.
Doing so means that the client will be paying that 37% tax on the converted assets. The upside, of course, is that the remaining funds swept into the Roth account can begin to regrow tax-free and later be drawn as retirement income — also without tax.
As Levine and Slott explore during the latest episode of their podcast, The Great Retirement Debate, it’s not obvious whether “locking in” the 37% tax payment on the conversion will be beneficial or harmful for clients over the long term.
On the one hand, many people — including the affluent — see their incomes fall during retirement, so it’s often assumed that future income will be taxed at a lower bracket. This makes the traditional account seem more attractive.
Conversely, there’s good reason to believe that taxes will need to be raised — perhaps substantially — to cover growing government costs and debt. This means that the top 37% tax bracket could become the second- or third-highest bracket in the future. There’s also no guarantee that a taxpayer's income will fall when including a potential inheritance or stronger investment performance than expected.
“Like so many other questions we discuss on this podcast, the answer to whether doing Roth conversions at the 37% tax rate makes sense is not black and white,” Slott said. “The answer is: It depends.”
Thinking Through the Math
Levine offered up another piece of guiding wisdom that is often repeated on the podcast.
“We could throw out spreadsheets and all sorts of calculators and things like that to determine the answer for a given client situation,” Levine said. “But suffice it to say that, in general, if you believe your income tax rate in the future will be higher than it is today, then you should probably convert to a Roth.”
Those who believe they will be at a lower rate in the future should probably wait. The ultimate rate of taxation, of course, is determined by how much income is being drawn in a given year and where tax brackets are set at the time.
“Now, if you think you're going to be relatively stable, and you think your income tax rate will be the same in the future as it is today, there is actually a slight mathematical advantage to the Roth,” Levine said. “One big reason why is that Roth accounts don’t have required minimum distributions.”
As such, money in a Roth account can potentially experience additional growth due to not needing to be liquidated as quickly. The Roth dollars also won’t face taxes on dividends or capital gains.
“With a traditional account, you'll be forced to take out some money each year once RMDs kick in,” Levine observed. “Even if you don't need it and you reinvest it, then those reinvested dollars will face taxes on the interest, dividends and capital gains. With a Roth IRA, during your lifetime, you never have to worry about that.”
These factors can make what would otherwise look like a less efficient income planning approach in the immediate term deliver substantial benefit in the distant future.
Future Flexibility
In Slott’s experience, many clients assume that their income in retirement will fall more than it does.
“A lot of people assume that, because they are no longer getting a paycheck and a W-2 in retirement, of course they’re not going to be in the top tax bracket,” Slott said. “In reality, many people who are in the top tax bracket now still are in retirement. Your IRA continues to grow and compound, and then when you hit RMD age, your RMDs alone could push you into that bracket.”
People also often fail to realize that many of the tax deductions they had enjoyed — like mortgage interest deductions, 401(k) contributions or child tax credits — aren’t going to be there in retirement.
“A lot of people end up having higher incomes and less in deductions,” Slott observed. “So, that raises the question, why worry about the possibility of seeing your income stay the same or grow higher and then run the risk of facing higher tax brackets in the future? If you convert now, you’re locked in.”
Pictured: Jeff Levine and Ed Slott
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