Best Roth Conversion Tax Strategy

There are many articles claiming to have the Best Roth Conversion Tax Strategy. In the end it all comes down to individual situations. Where they are or will be in the tax rates as they progress through their retirement and of course their age.

Those of us who managed to save and invest our way to a large IRA account should understand tax impacts. Depending on our tax rate that IRA balance showing under our control is not all ours. We WILL be paying taxes on that money.

The question becomes, do we pay it now or pay it later? The answer is pay it now only if it means paying a lower rate than we would have to pay later on. The idea is to try to maybe save thousands of dollars in taxes paid out from that balance we keep looking at.

The Best Roth Conversion Tax Strategy is About More Than the IRA

We saved and invested within 401K and IRA tax advantaged accounts to fund our retirement. That money was non-taxed income during our rat race years. The deferred-tax sales pitch of course was that when you retire your income will be lower. Save now and pay a lower tax rate on this income later in retirement.

While we were working our tax rate may have averaged 20%, 25% or higher as we worked our way through our career. As an example, saving 25% in taxes on this income now and only having to pay 15% on our lower-income in retirement. It sounds like a win-win scenario.

However there are many things to consider in retirement that may make staying in the lower tax bracket difficult to accomplish. That and the impacts our IRA withdrawals will on our Social Security. The IRA most will likely cause what could be a tax-free Social Security check to now also be taxable. Especially when considering Required Minimum Distribution (RMD) withdrawals that start at age 70 ½.

The Best Roth Conversion Tax Strategy is About Timing

When it comes to Roth Conversion, timing is about your current tax bracket. That meaning the best time for making a Roth Conversion is when you are in a lower tax bracket. For most people it will be when they retire and start living off of their portfolio. That money funding our retirement lifestyle is of course taxable when it is taken from our IRAs. If you are like me, my early retirement lifestyle costs keeps my tax bracket at the 15% rate.

If that was all I had to consider then Roth conversions would not make much sense. Pay 15% tax now (if I limit my Roth conversion to keep my total income within that tax bracket) or pay it later when I make normal withdrawals. But as I mentioned above we have to consider Social Security. Even though Social Security will carry some of the load of funding my retirement and reduce my taxable IRA withdrawals. The Social Security tax thresholds are so low I will now have to also pay taxes on Social Security. With Roth Conversations I may have an opportunity to save myself taxes all around.

You may be thinking why bother. So you have to pay taxes on up to 85% of your Social Security. You pay 15% on 85% of that Social Security income instead of 15% on the full amount of a Roth conversion. There is a problem. That thinking is short-lived.

Depending on your IRA portfolio balance and once RMD begins you just might jump into the higher tax brackets. Waiting until then and you will have little or no options left to do anything about it. At best you pay now the same tax rate you saved while a wage slave. At worst you now pay a higher tax rate. But remember that now you are also dragging your Social Security into that equation. Who wants to pay 25% tax on 85% of their Social Security income?

When to Consider Your Best Roth Conversion Tax Strategy

From what I have learned the best time to consider Roth Conversions is after you retire and before you start collecting Social Security. This is especially true if you intend on funding your retirement with non-retirement savings and investments. That will usually result in having very low taxable income in those years.

Even when using my IRA to fund my early retirement I only have about $40,000 in taxable income. If using the 2014 tax bracket info that puts me at the 15% rate (Married filing jointly from $18,151 to $73,800). After subtracting out our Standard Deduction and personal exemptions we will only have $19,700 taxable at 15%. This gives me the opportunity to convert to Roth up to $54,100 ($73,800 – $19,700 = $54,100) and still remain in the 15% tax bracket.

I then can manage my taxable income by reducing IRA withdrawals and supplementing my income with Roth funds. I can limit the taxable IRA withdrawal to just below the Social Security taxable income limits once I begin receiving payments.

Things to Consider
  • Roth Conversion taxes are due in the year of the conversion. It is recommended that you convert to Roth what you can pay in taxes from non-retirement accounts.
  • If your IRA balance is not overly large then RMD may not be a huge concern. But still consider it and do some math. At age 70 1/2 the RMD factor is 27.4. If using as an example of a combined joint filing tax payer with total IRA assets of $900K. They would be forced with RMD to withdraw $32,847 and pay taxes on it. Whether they need that much or not. That amount definitely sets you in 50% of your Social Security being taxable. Depending on the amount of your Social Security, it could put you in the 85% of Social Security taxable rate.
  • Each year the RMD factor increases and may cause tax bracket creep.

In Closing

Nobody knows where taxes will be. Make the best decision based on what you know now. If you have concerns, questions, or need help in figuring out whether there may be a Best Roth Conversion Tax Strategy then seek the advice from a Certified Financial Planner.

If you have any questions or want more details about Social Security becoming Taxable or Required Minimum Distributions (RMD) please see my pages:

Social Security Tax Strategies

Required Minimum Distributions Loom


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