When most people think of Roth conversions, tax benefits are usually what come to mind. After all, the prospect of never having to pay taxes on the growth of your investments sounds pretty good. Also, the sense of finality, like paying off your mortgage, has a nice appeal.
But before going all in on Roth conversions, it might be prudent to take a step back to see how your Roth conversion strategy might intersect with other priorities in your life.
Most Tax Efficient—What Does That Mean, Anyway?
What is tax efficiency? Generally speaking, tax efficiency is being able to pay the lowest amount in taxes. Since most people think of taxes as an annual engagement, it might make sense to think tax efficiency means simply paying as little as possible year over year.
But this approach might compel you to defer Roth conversions each year, basically kicking the can down the road. Then, at some point, Social Security and required minimum distributions (RMDs) force your income to go up. And all those years of ‘tax efficiency’ backfire as you’re compelled to take income (and pay taxes) on money you might not have planned on.
It might serve to think about tax efficiency over time. That is, paying the lowest amount in taxes over the course of your lifetime. For many people, the ‘sweet spot’ is that time between retirement and age 70, when Social Security payments start (or should start for people looking to maximize their Social Security payouts). And most people, even those with large retirement accounts, are able to identify their ideal tax bracket for Roth conversions and create a Roth conversion strategy that gets everything converted before those dreaded RMDs start.
But is avoiding RMDs the only priority?
Are RMDs really so bad?
In a word, no. But when considering Roth conversions, it seems that our goal is to get everything converted before RMDs start. Implied, but not directly stated, is the thinking that if there’s money left in an IRA when RMDs start, then we ‘lost.’ By that,
- You can’t do Roth conversions after you’ve started taking RMDs.
- We could have converted more at some earlier point
- We ‘left money’ on the table
- We’re going to pay more in taxes
Except for the first one, each of those things could be true, but they’re not necessarily true. Let’s look at each of these in a different light.
- You can’t do Roth conversions after you’ve started taking RMDs. Sure you can. You just have to take your RMD first and your RMD be used as a Roth conversion. After that, you can do Roth conversions like any other taxpayer.
- We could have converted more at some earlier point. You can always look back and say this. But just because you ‘could’ve’ doesn’t mean that you ‘should’ve’. And if tax-efficiency is a focus point, then there are any number of scenarios in which it would have been less tax efficient to try and convert more into a Roth account in earlier tax years.
- We’re going to pay more in taxes. This is a valid, but not always accurate, concern. The RMD is simply a required minimum distribution. Let’s imagine that you have been converting $50,000 per year into a Roth IRA. It’s now your first RMD year, and your RMD is $20,000. You could have a Roth conversion strategy that simply has you converting the remaining $30,000 (after your $20,000 RMD), instead of the normal $50,000 that year. You don’t pay any more taxes on your IRA distribution if it’s an RMD than you would if it were a Roth conversion.
- We ‘left money’ on the table. This seems to happen to a lot of people concerned with ‘winning.’ I can’t really identify with this as a cornerstone of investment philosophy, so when this comes up, I try to help visualize what’s to come. And usually, it’s good things.
Let’s look at the case of someone with a $1 million IRA, starting at age 60. Even if that person reduces their IRA to $500,000, their eventual RMD will be about half of what it would have been. And depending on your intent (see below), that might be good enough.
If you’re planning to leave some of your accounts to your children, grandchildren, or other relatives, then you might do well to consider their tax brackets. If your beneficiaries are relatively low tax bracket, then you might be okay with leaving a significant amount in the IRA. This would make sense if you think that they’ll eventually pay lower tax rates than you would, and if you think that the revised IRA distribution rules (thanks to the SECURE Act) won’t cause their taxes to spike.
On the other hand, your beneficiaries might be high earners, already paying premium taxes, and inheriting an IRA would only add to their tax misery (with the understanding that after taxes, even part of something you never had is better than nothing at all). In that case, you might decide that you’re going to pay taxes on Roth conversions so that your beneficiaries don’t have to worry about it. And for some people, that might be the priority, even if it’s not the most ‘tax-efficient’ strategy.
But, if your money will eventually go elsewhere, why pay taxes at all?
If you’re charitably inclined, there are a couple of other tax planning opportunities you might consider. And if they’re a part of your plan, then Roth conversions might be less of a priority. Let’s look at two of them:
Qualified Charitable Distributions (QCDs)
The Internal Revenue Code allows for a taxpayer, starting at age 70 ½, to directly disburse up to $100,000 per year from his or her IRA in the form of a QCD. QCDs are not considered to be taxable income. Rather, they are simply not included in your tax return calculation (they are included in your tax return, simply because your tax professional will have to declare how much of your IRA distribution was a QCD). For those of you who might be itemizing charitable contributions on Schedule A, QCDs are a more tax-efficient way to support charitable causes. And for those of you who have to take RMDs, your QCD counts towards your RMD—so if your planned charitable distribution is more than your RMD, and you don’t take any additional money out of your IRA, you don’t have to pay taxes on IRA distributions that year.
So for your pre-tax accounts, it is possible to never pay taxes:
- On the way in: Because they were either deducted from your tax return (IRA contributions) or not included in your taxable income (employer-sponsored retirement plan contributions).
- While they were growing in your account: Because investment gains in a retirement account are tax-deferred.
- On the way out: Because you don’t have to pay taxes if the QCDs go directly to a qualified charity.
This is pretty much the holy grail of tax planning. Other than health-savings accounts, there aren’t many of these opportunities available to most taxpayers. But there is another one worth pointing out.
Did you know that you can designate charities as beneficiaries? Yep. And by doing this, you bypass the tax concerns you might have with estate taxes (if that’s a concern for you). Again, you may consider this for those assets that you haven’t paid taxes on yet (namely your IRAs).
When creating and implementing your Roth conversion strategy, taxes are an important consideration. But depending on what’s important in your life, they might not be the only consideration.
Interested in reading more about Roth conversions? Check out Lawrence Financial Planning’s Roth conversions articles page. Here you’ll find lots of articles that we’ve written about Roth conversions. And if you’re ready to hire someone to help you create, implement, and maintain your Roth conversion strategy, contact us. At Lawrence Financial Planning, we would be more than happy to schedule a complimentary phone call to see how we can be of service to you.