Taxes could be going up, so how can you capitalize on your current tax rate?
One tax-smart move to consider is converting some of your IRA into a Roth IRA in what’s called a Roth conversion.
We first wrote about the advantages of a Roth conversion in 2020, which was an ideal time to convert given that required minimum distributions or RMDs were waived. However, there are still good reasons to consider a Roth conversion in 2021. Here’s what you should know:
Quick refresher: How Roth conversions work
When you convert your traditional IRA retirement assets to a Roth IRA, you’ll pay taxes on the amount you convert, and then that money can then grow tax-free in a Roth IRA. It’s a way to shield your retirement savings from future tax increases—and avoid required minimum distributions (RMDs).
You may flinch at the idea of purposefully increasing your taxes now, but as the New York Times explained: “For many wealthier people, it may make more sense to pay the taxes now rather than risk a rise in rates later in the year, particularly if you were going to do something that would incur the tax anyway.”
From a financial planning perspective, there are a few important factors to consider that can increase the cost of a Roth conversion if you aren’t careful. FundX’s Certified Financial Planner Rohan Nayak shared when it’s best to convert your IRA and four factors to look out for:
The sweet spot for Roth IRA conversions
We believe the sweet spot for Roth conversions is the period between the time you retire and the time you turn 72 (RMD age). Your income typically drops after you stop working, and it tends to remain low until you start taking required distributions from your IRA. Lower income generally means lower taxes, so this may be a time when you’re in a better position to pay the additional tax on the assets you convert to a Roth. However, even within this sweet spot, there are a few potential negative consequences to a conversion, that you should know about.
Four factors to consider before a Roth conversion
1. Medicare high-income surcharge
If a Roth conversion increases your modified adjusted gross income above a certain amount, your Medicare Part B premium can jump between $200 to $500 a month. This surcharge often catches many retirees by surprise because it is based on your tax return from two years ago.
If you are considering the cost of a Roth conversion, you’ll want to factor in the potential for a one-year hike for Medicare premiums along with a higher tax bill. One way around this is to complete your Roth conversions by age 62: this will avoid the two-year look back that begins once you turn 65 and sign up for Medicare.
2. Taxes on Social Security benefits
The additional income from a Roth conversion could increase the portion of Social Security benefits that are subject to federal income taxes. Up to 85% of your Social Security benefits are taxable, depending on income from other sources (job, pension, withdrawals from IRA, Roth conversion).
To manage this, you could delay taking Social Security until after you have converted money to a Roth. Additionally, you’ll receive 8% of social security benefit credit for each year you delay taking your benefit until age 70.
3. Taxes on investment income
Most taxpayers pay a 15% capital-gain tax rate on income from long-term capital gains and qualified dividends. But a Roth conversion will increase your taxable income, and if you aren’t careful, that could increase the taxes on your investment income, too. The additional income from a Roth conversion could push you into the higher tax bracket for capital gains (20%).
The 20% capital gains rate kicks in when your 2021 taxable income tops $501,600 for married couples filing jointly. Add in 3.8% Medicare surtax on net investment income if your modified adjusted gross income tops $250,000 for married couples, and this brings you to the top capital gains rate of 23.8%.
4. RMDs come first
Required minimum distributions (RMDs) were waived in 2020, but they’re back in 2021. You have to take your RMD before you can convert part of your IRA to a Roth. So you might consider taking your RMD earlier this year since the dollars that come out from your IRA first count towards satisfying your RMD. Once that’s satisfied, additional dollars can be converted to a Roth.
Roth IRA Conversions at FundX
Here at FundX, these are some of the factors we consider when helping our wealth management clients with Roth conversions, and we partner with CPAs and accountants to make sure we stay up to date on the latest tax changes.
We also have a program that helps us analyze these four factors and the potential tax consequences of a Roth conversion and helps us create a plan that allows clients to convert IRA assets to a Roth over time, so they are converting just enough to remain within their current tax bracket.
Talk with your advisor to find out if a Roth conversion makes sense for you. If you don’t have an advisor, this could be a good time to partner with an advisor who can help you make tax-smart decisions now that could pay off if taxes go up later. Reach out to a FundX advisor here to set up a free introductory conversation.