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Partial Roth Conversions:  What Are They and When Should I Do Them? Thumbnail

Partial Roth Conversions: What Are They and When Should I Do Them?


Tax planning is one of the biggest pieces to the retirement planning puzzle. The fact is that over the course of your retirement, your biggest bill is probably going to be your tax bill. So there's a number of steps that we can take to try to mitigate that over the course of your retirement, one of which is doing Roth conversions. So today I want to talk a bit about Roth conversions and more specifically partial Roth conversions. Just explain what they are, in a really simple way and, and why you might want to use them. So first I wanna introduce myself. My name is Warren Burger. I'm the owner of Luminary Financial Advisors. we're based in Cocoa Beach, but we work with people all over the country and we try to create tax efficient retirement plans for people. So the first thing I think I have to address is what is Roth conversion, right?

We hear about this bantered about all the time, and unless you've actually really done a little bit of legwork, you might not know what it is. So basically it's the idea that we're taking, a lot of us have been saving into our 401ks over the course of our lifetime, 403b you know, any, any tax deferred retirement savings account. And we all know that eventually the tax bill is gonna be due as we take money out later, and it's gonna come out in the form of ordinary taxes. Well, the idea of a Roth conversion is to take money from that tax deferred account that you already have set up and moving it into a tax free Roth account. The idea being that it now will be tax free for the rest of your life and growth in that account will also be tax free.

So the, the key to understanding this is that you're going to have to pay taxes on the money that you convert from that tax deferred to the tax free Roth. And you're gonna be paying at the tax rate based on what your income is for that year. So if you have income from other sources you're also taking money from, say, your IRA or your 401k all adding to your income. Anything that you convert from that tax deferred account to the Roth is going to be taxable. And so we always have to be wary of whether or not we're gonna push ourselves into the next tax bracket. Now, if you turned around and say you had a million dollars in your, in your ira, and now you wanted to convert that over to a Roth, you could do that, but you'd be paying taxes on the full million dollars that you converted over to the Roth.

And so that's gonna push you into multiply higher tax brackets, not necessarily the best idea. This is where the idea of doing partial Roth conversions over a period of time, a really systematic way of doing this, allows you to take advantage of your current tax brackets and move parts of your tax deferred money into that tax free Roth. So you're probably asking yourself, why would I want to do that? And the idea is that we're looking to try to pay taxes now at the tax rates we have now if we believe that tax rates or tax bill is going to be higher in the future, why would my tax bill be higher in the future? Well, there's three things that come to mind that I wanna talk.

First is we have the tax cut and Jobs act that was established in 2017. that sunsets in 2025. So going into 2026, unless Congress does something to, to, to change this, where are all of the current tax rates we have now are gonna be going higher. The second reason your tax bill might go up is just looking at sort of the, the economic outlook of the country. So we have 32 trillion in debt. We have a debt to G D P ratio. So the amount of debt we have versus the what we're bringing in over 100% at this point it seems to me that the most likely way the government's gonna try to make up these deficits in the future will likely involve some raising of taxes. you may believe differently. but it, it does seem as though that is a potential threat for us going forward.

Reason number three would be required minimum distributions that you have to start taking at age 73. So once you turn 73, the government requires you, they're gonna want their money. Eventually, they require you to take a set percentage of your tax deferred assets out whether you need that money or not. And so that money could propel you into a higher tax bracket. So those are just three reasons why we might think that tax rates are going higher in the future. Now, the most opportune time to do these Roth conversions is generally between the time that you retire and up to the age that you're going to start taking required minimum distributions, which in 2023 is age 73. And the reason for that is a lot of times people find themselves in a lower tax bracket because they're no longer receiving income after they retire.

 there might be other forms of income, whether they're pensions like another spouse working, things like that. But you're, you're likely to have lower income, certainly than you did before you retired. And so there is a period of time there where there's that lower income that we can start to fill in tax brackets by moving this money from the tax deferred account to the tax free Roth, and we pay the tax on those movements that we make. So what might be an example of this? So sitting here in 2023 if you're in the 22% tax bracket that bracket goes from roughly 89,000 in change to 190,000 in change. So if your income falls within that range, you're paying that 22% on, on every next dollar that, that you make in terms of income. So let's say that you had a hundred thousand dollars in income come in this year whether that's from a pension, like I said before, a a spouse's income or any other income that you have, your income and, and potentially money that you're taking from your retirement accounts. Let's just say that your income sits at a hundred thousand dollars. Well, that means we have approximately $90,000 to play with of these partial Roth conversions before you would

Hit the next tax bracket. So if we want to continue to pay taxes in that 22% bracket, we can choose, and it doesn't have to be the whole 90,000, it can be any part of that. Let's just say we decided to do a $20,000 conversion. So now your a hundred thousand dollars income now becomes $120,000 of income. We're gonna pay taxes at the 22% rate on that, a additional 20% $20,000 that we moved over to the tax free Roth account. And the idea being that if we find ourselves in a few years where that same $20,000 was gonna have to be moved, but now the tax rate is at 24 or 25%, well then you made a good move in doing that at 22%. And not only is it the fact that you move that money initially over there and that, and, and you paid that 22% hopefully lower tax rate, but now that money is gonna grow in a tax-free basis.

So when you decide to take that out in the future, that growth was tax free as well. So it's almost like a a tax mitigation compounding effect that goes on. The partial Roth conversions are a really valuable tool to lower your lifetime tax rate. And we've seen examples where we've run the numbers and there could be hundreds of thousands up to millions of dollars depending on what your portfolio looks like in tax savings over the course of your life by doing these periodic partial Roth conversions. Now there's a couple moving parts here in terms of the irs. there's a additional form that has to be filed when you do you have to report this to the irs. So the idea being that you wanna make sure that you're working with your accountant, you wanna make sure that you're working with a financial planner to make sure that you're managing these tax brackets accurately.

 but like I said, it's a super powerful way to mitigate your tax bill over the course of your retirement. So I hope you found this helpful. if you look in the comment section below, I have a number of flow charts and checklists on retirement issues that I think are really helpful. and if you wanted to talk about your personal financial situation, I have a link to my personal calendar 30 minute complimentary conversation just to see where you're at. And I always make sure whether people are working with me or, or not, that I'm gonna steer them in the right direction. It's really important to me that no matter who comes to me, they feel like they got some value out of the experience. So like I said, I hope that's been helpful for you and I hope to see you on the next video.