Planner’s Corner: Roth Conversions

Planner’s Corner is a series of posts on financial planning topics that relate to personal experiences, preferences and opinions of the author. As with any content on this site, nothing is intended to be personal financial advice. That is, after all, personal. The author recommends a fee-only CFP® for your personal plan.

I’ve touched on this one before when taking a look at “Backdoor” Roth conversions, I want to revisit it one more time in a more general sense.

Timely revisit also for me personally, as this will be the first year I will be pulling the trigger on a Roth conversion myself. I will get to the “why” a bit later, but first let’s get some basics out of the way. I will link to some articles later as well.

TAX BRACKETS

Roth conversions create a taxable event. That said, the number one reason most decide to do the conversion is they feel that either 1) they will be in a higher tax bracket later or 2) they think the tax brackets themselves will creep higher later!

Read #2 again. That is often overlooked. The election is less than 30 days away, do you think the winner could have a potential impact on future tax brackets?

I think conversions will increase these last two months of this year precisely for that fact alone.

That is not a factor for me personally because at this point as an early retiree my income is 100% passive. I decide in advance what it will be, so I have total control over my brackets and where I ultimately land.

Roth conversions, depending on their size, could increase your overall tax bill by pushing you into higher brackets. That’s a very big consideration. It may be better off to do this over the course of several years for that very reason, more on that later.

GOT CASH?

Since we know this is a taxable event, the first question you need to ask is how you will pay the bill? Is this a large deduction year? Is this a lower income year? If not you will be on the hook for the bill and it (really) needs to be paid from liquid funds, not conversion funds or other sources.

If you do your own taxes with software use that software to play a little “what if” and model some various scenarios. I do this all the time and I think it’s one of the most overlooked ways to plan.

Yes, you are looking backwards at this year’s tax filing, but it can help going forward just as well. I have modeled several items where I have realized I probably don’t want to do that.

Bottom line here…determine what you will owe and how you will pay it.

Bridging the Gap

My last employer paycheck was deposited in late June 2021. I had some deferred stock compensation to scrub off the next couple of years but pretty soon it was all on me.

This creates a very intriguing opportunity for potential tax-free Roth conversion space. Wait, you just said it was a taxable event, how could it be tax-free? Deductions.

Even the standard deduction for a single filer is $14,600. If you are bridging the gap between employment and retirement, as am I, chances are your taxable income is (or could be with some planning) quite low.

Now is the time to take advantage of those low income years to convert every penny you can, at the very minimum up to what you can convert tax free!

Time for a quick plug for a fantastic web resource I stumbled onto while planning this on my own a few years back: https://spintwig.com/fire-taxes/

There you will even find the option to pay for an Excel calculator to do the math for you. There is a calculator also to maximize your Social Security payout. Having been the creator of similar monster spreadsheets in my lifetime, much props to this fella for doing the same and monitizing it to boot. Why the hell didn’t I do that?

Bottom line here…if you find yourself with lower income years bridging the gap, determine how much you can convert either tax free or at reduced rates.

FIVE LEAN YEARS

When it comes to Roth conversions, the five year rule still applies also in its own unique way.

Conversions are hands off for five years starting in the year you convert. There are two good reasons to wait until December to convert: 1) you have a much clearer idea of what your true taxable income for that year is… and 2) the five year clock starts on Jan 1 even if you convert on Dec 30. Your hands off period is truly four years if you convert late.

So this has become a game for me personally, to see how much I can convert over the next five years at minimal (if not zero) tax outlay.

I will pull from liquid sources for short-term cash needs while avoiding capital gains and dividend income. My “income” will be primarily created from Roth conversion capital taking full advantage of the “lean years”.

I will revisit everything five years from now, when I am eligible for my corporate pension. I may be able to defer that longer than anticipated and increase my monthly payout. I am crossing my fingers for a buyout offer, but certainly not holding my breath.

Bottom line here…anything you can potentially convert tax-free should be done each year no questions asked. If you have the ability to create some lean years taxable income wise, it will be that much easier.

Healthcare Ace in the Hole

For those early retirees without access to employer healthcare, I feel you. I am footing that bill for 15+ years. The never-ending car payment. It sucks.

Turns out my Roth conversions will help foot the bill. As in 90%+ of the bill. Here’s how.

Healthcare and ACA subsidies kick in as long as your income is above the Federal Poverty Level. My particular state will kick in and reduce my premium in advance if my income is above the Medicaid threshold, let’s call it 5K above the FPL.

As of today, I am fully funding my own healthcare at the 100% premium. It’s over $500/month. Next year, as my open enrollment sits on my desk, it’s over $600/month. I have noticed over the last 3 years it has increased $100/month each year. Total bs.

The madness stops now.

I plan to create the taxable income needed to cash in on the PTC (Premium Tax Credit). Most people will bend over backwards to get help on the monthly premium up front. I can see why. I’ll pass on that but I will most certainly be reconciling at tax time.

Bottom line here…is if you are footing the bill for your own healthcare make sure you take full advantage of the PTC or payment assistance and try to make sure your income allows you to do so.

CONTRIBUTIONS ON TAP

If you are the proud owner of a Roth that you have dutifully funded over the years, please do not forget, those contributions are available to you on tap at any time tax free.

So as we talk about all of this conversion minutiae, that has absolutely no impact on your personal contributions. Conversions are second in line.

When you request funds from your Roth, as I have done on multiple occasions, the first pool accessed will be your personal contributions.

Do you know how much you have contributed? If not find out. Create a spreadsheet of your “basis” if you plan to take withdrawals. Your basis will consist of your contributions minus any withdrawals for a given year.

Don’t rely on your brokerage to do this for you. Keep track of it yourself.

Bottom line here…is to always remember your contributions are yours to withdraw at any time. Just make sure YOU keep track of your running cumulative basis – your contributions minus any withdrawals.

On Balance

If you are fortunate to have both tax-deferred IRA’s and Roth IRA’s you have flexibility. Two separate buckets to pull from as needed and also two separate buckets providing conversion flexibility.

Tax-deferred IRA’s are great, but if you can convert a portion tax-free each year to a Roth you should do so no questions asked.

If you can convert a portion at reduced rates for a particular year, consider it.

If you have the ability during lean years to take advantage of a conversion window, consider it.

If you have the ability to use Roth conversions or other income sources to take full advantage of ACA subsidies or the PTC, consider it.

If you have a substantial amount of Roth contributions (remember they are always first in line) and you need access to liquid funds, consider it.

If you decide to tap Roth funds for whatever reason, take the time to calculate your basis and make plans to track it yourself.

If you are considering early retirement, make sure you fully evaluate the role your IRA’s and potential Roth conversions have on your tax and healthcare planning.

All for now! Audi 5…