When developing your Roth conversion strategy, one of the most common considerations is what tax bracket you’ll be in when you do Roth conversions. Arguably, one of the goals of doing Roth conversions should be to keep your taxes as low as you can practically make them.
As part of that strategy, you might consider not just keeping your taxes low for the current year, but for the period of time that you’re doing Roth conversions. Usually, a goal would be to determine what the ‘ideal tax bracket’ might be for your situation, then to use that as a target for planning your annual Roth conversion amounts.
While it sounds fairly straightforward, it might not be as easy as it sounds. The goal of this article is to help you understand some of the obstacles that might present themselves so you can determine what your ideal tax bracket might be. Let’s start with what’s obvious.
What’s obvious—The desire to keep your tax bracket as low as possible
That’s pretty straightforward. But what makes this challenging is that you’re probably not looking at this from the perspective of just one year. After all, the goal of Roth conversions is to keep your taxes relatively low today, as well as low in future years, when it might be more difficult to do so.
For some people, it might be a realistic goal to do all Roth conversions while remaining in the 12% ordinary income tax bracket. This is an ‘ideal’ tax bracket because capital gains (which are always taxed in a preferential manner to ordinary income), are taxed at 0%. This is great for people with lots of unrealized capital gains (think old stocks and mutual funds that you’ve had for a long time which you haven’t sold yet). Being in the 12% tax bracket enables many people to unwind their capital gains over time without having to pay taxes.
But you might not be in this position. If you and your spouse have $5 million in your IRAs, and you’ve only got 10 years before you take required minimum distributions (RMDs), you probably won’t be able to convert everything at the 12% tax bracket. And once you’ve started taking RMDs, they might be high enough to keep you out of the 12% tax bracket.
For some people, the ‘ideal’ tax bracket for Roth conversions might be 22%, 24%, or even 32%, for people who are trying to stay out of the 35% or 37% tax brackets. In order to do this, you’ve got to look at all the factors that might interfere with your efforts to keep your tax bracket as low as possible.
What’s not obvious: Everything that might keep you from the lowest possible tax bracket.
What does this mean? Well, pretty much everything—from sources of income, to your account balances, the amount of time you have, to your goals, and tax planning opportunities you might otherwise overlook.
Income: Of course, when you look at the sources of income that might impact your tax picture, the first consideration is required minimum distributions, which now begin at age 72, thanks to the SECURE Act. One of the most common goals of Roth conversions is to avoid RMDs in the first place. However, below are some other income-related things you might consider:
- Social Security (and when to decide to start taking it, if you haven’t already)
- Your employment situation
- Deferred compensation
- Stock options
- Unrealized capital gains
All of these might cause your taxable income to go up, thus decreasing the amount you can convert in a given tax bracket.
Account balances: In this regard, we’re talking about your pre-tax accounts (IRAs, 401ks, and deferred compensation plans). The higher your account balances, the more income you will eventually realize. The more income you realize, the more you will eventually pay in taxes. But there are still ways you can keep this low, particularly if time is on your side.
Time: Sometimes, you might be starting early enough to be able to reasonably convert even high account balances. Someone who ‘retires’ or achieves financial independence in their fifties might have 15 or more years to fully convert their accounts.
Other times, you might not have that option. Someone retiring at age 70 might have to convert as much as they can, and make the most of what they can do.
Goals: All of the above ties back into your goals. Your goals should simply reflect the things you want to achieve. For some people, the most important goal is getting their lifelong tax bill as low as possible. For others, they might want to pay the taxes on their Roth conversions so their IRA beneficiaries don’t have to. Other people are more focused on cash flow, and less on taxes. And finally, some people might have charitable intent. Whatever your goals are, your tax planning opportunities come from.
Tax Planning Opportunities: Your tax planning opportunities might not drive your decisions (nor should they), but they might influence how those decisions are implemented. Of course, those tax planning opportunities might be different based upon your situation.
For example, let’s look at two couples who are both charitably inclined. Couple A has a lot of money in retirement plans, while the Couple B has a lot of appreciated stock. The tax planning opportunities for Couple A might focus a little on actually not converting everything from their traditional IRAs, but planning for their eventual RMDs to be distributed as qualified charitable distributions (QCDs). Since QCDs are tax-free, this is a very tax-efficient way of supporting their favorite charities. Conversely, Couple B might best benefit by donating their appreciated stock, either directly to the charity or through a donor-advised fund, and maximizing their charitable contributions on Schedule A of their tax return.
Each family situation is different, and has different tax planning opportunities. The challenge is finding the opportunities that apply to your situation and to strive towards the lowest practical tax bracket for your situation.
What’s the way forward: Striving towards the lowest possible practical tax bracket for your situation.
This is where the rubber meets the road. Once you’ve laid out all the facts, you start trying to put the pieces together for your Roth conversion strategy. You should have enough information to actually do this.
Just because you have the information doesn’t mean that it’s any more straightforward than it was before. For many people, this is not intuitive, and it doesn’t come naturally. Moreover, the tax law changes often enough to stump even the smartest non-tax professionals who think they’ve been able to figure it out.
And that’s where your tax-focused financial advisor comes in.
What’s involved? Taking a strategic view of what your true priorities are, then using those fundamental priorities to help you determine what’s practical.
Moreover, your financial advisor should be helping you evaluate your tax situation every year, keeping on top of changes, and helping you make adjustments to your Roth conversion strategy as necessary.
Tax bracket management is just one of the myriad factors that go into creating and executing your Roth conversion strategy. If you don’t feel comfortable doing this yourself, you should talk with your tax professional or financial advisor.
And if you don’t have one, contact us. At Lawrence Financial Planning, we’d be more than happy to look at your financial situation to see how we might be able to help you create, implement, and execute your Roth conversion strategy.