Should I Consider a Roth Conversion before I Stop Working?

Peter, good to see you.

We're going to start with a question that comes up all the time. Should I consider a Roth conversion before I stop working? Roth conversions, as we know, can be one of the best strategies to create tax-free income in retirement, and those accounts can grow tax-free indefinitely because they have no required minimum distributions. What are the key benefits of doing a Roth conversion while you're still working as opposed to waiting until you're retired?

Well, I was going to say tax-free income in retirement and tax-free inheritance, but caveat to remember there, your second line there doesn't have required minimum distributions. If it passes to the next generation or anyone other than a spouse, even Roth IRAs do have that 10-year rule where they must be liquidated. So, yeah, there are advantages to Roth conversions, and the big advantage is if taxes were to go up into the future. You know, if tax rates stayed the same forever and ever, if they were etched in stone never to change, then it's pretty much six in one, half dozen in the other.

If the growth rate's the same on a tax-deferred account versus a Roth, then there's no huge advantage to conversions. But tax rates are at historical lows right now, and we have $37 trillion in debt or closing in on that number exponentially fast. So taxes have to go up into the future. The Congressional Budget Office's latest report showed that before Congress even whispered about spending any money, we actually spent 100% of all the tax revenue that we brought in and interest alone on the debt last year surpassed a trillion dollars. And then Congress does like to spend money.

And so at some point in time, there's only so many ways to fix this problem. We're not going to cut back on non-discretionary mandatory spending, Social Security, Medicare, and interest on the debt. We're probably not going to see Congress judiciously cut their own spending, just doesn't happen.

So there's three sides to this triangle. The other side is tax revenue. They have to bring in more tax revenue. And so I worry that given that we do have currently pretty low historical tax rates, that at some point, those could probably go up into the future.

Now, as tax laws stand today, asterisks in bold, as we record this program, as tax laws stand today, they are already slated to go up at the end of this year. 2025 is the last year under the 2017 Tax Cuts and Jobs Act. And then the 12% bracket becomes the 15. That's not a 3% tax increase. That is a 25% higher tax bill on the dollars that fall into that bracket. The 22 becomes 25.

The 24 becomes 28. So tax rates are already slated to go up. Tax law currently on the books is that taxes will be going up. They could get pushed back, those increases, the expiration of the 2017 Tax Cuts and Jobs Act could get extended. But we've got to operate under what we know today. And then even if they do get extended at some point in time, taxes still need to probably go up about 30% even to get to historical average tax levels. And again, we've got a spending problem, we've got a debt problem. So the question, sorry, long, long winded kind of set up there. Does it make sense to do it during your working career versus when you retire?

Sure, it does. You've got to crunch the numbers here, but there are some advantages while you're working. You've got a paycheck with which to pay that bill. After you retire, you've got this finite amount of money and an unknown amount of time that you need to make it last and trying to manage taxes once you've retired, once you no longer have a paycheck, it's just easier to pay bills while you have an income. Now, that being said, there may be some advantages post retirement as well, being that you don't have an income. So your income generally is probably not as high as it was during your working career. You might not be in as high of a tax bracket. If there's a substantial difference between your income during your working career, your paycheck income and your actual spending in retirement, then you could theoretically drop tax brackets.

Brackets are pretty wide. I don't see as many people paying substantially less in taxes in retirement as what was once kind of thought and portrayed. Like it's also not written in stone that retirees pay less in taxes and many, many, many of them find out that they don't. They actually pay as much or more in taxes in retirement. But all that said, there's an advantage to either side, especially if taxes change and increase into the future. Managing those taxes for the lowest potential cost possible is really the name of the game, right? The linchpin to answering this question revolves around taxes. So what do we need to take into account when considering our current tax bracket and how a Roth conversion could affect our taxable income? Well, it's going to make the taxable income go up right at your baseline is call it one hundred and fifty thousand married filing jointly household income.

And then you do another fifty six thousand seven hundred and one dollars in twenty twenty five. You just bumped yourself up into potentially the next highest tax bracket. And I know deductions. I'm not factoring those in.

So there's the math is not quite exact there. But point being is you've got to figure out where your income falls today and then the Roth conversion is going to add taxable income. On top of that, you've got to think about all kinds of considerations. You've got to especially, you know, from sixty three and beyond, you've got to think about potential implications to Social Security taxation, potential implications to Medicare premiums that can be means tested if your income goes up over certain thresholds. And really what we need to look at is where does your income fall today?

And then let's project out into the future and say, where does your income fall once you have retired if you're still working? Do we have any kind of reasonable expectations that you will dramatically cut your income and be in a lower tax bracket? If so, then perhaps those traditional tax deferred contributions do continue to make sense. But if we're going to be in approximately and foreseeably the same tax bracket, then probably the Roth contributions and some Roth conversions make sense.

Being careful to try to maximize the current bracket and not bump yourself over into even higher tax rates. Are there any penalties or limitations we should be aware of when converting these pretax accounts to Roth accounts before we retire? Well, I mean, taxes, that's not a penalty. But when you convert from your your left pocket to your right pocket tax deferred to the Roth tax free, you've got to pay taxes taxes while those dollars are in transit.

So just be prepared for that. There are no penalties, limitations, right? There are limits on how much you can contribute new dollars into the Roth retirement accounts or any retirement accounts. They all have limits and limitations, but there are no limits to how much you can convert. Likewise, there are some income limitations. If you make too much, you're not supposed to be able to put money directly into a Roth. There are some ways around that for higher income earners, but be careful in how you're executing that. But there are no income limitations on Roth conversions. So once the money is already in a traditional account, like a traditional IRA, to move it over to the Roth, you have alleviated yourself of all of those income limits and those thresholds for capping how much you can put in.

The government would love you to roll over as much because they get to collect those tax dollars now. So the only other thing there, if I mentioned the higher income earners, if you are doing the back door Roth conversion, do be very, very careful because if if you are executing that strategy, you've got to make sure that you've got no other IRA assets. Otherwise, the second step of that backdoor Roth conversion is going to be considered pro rata as a proportion of your total IRA balance. So you need to consider that that pro rata rule will sneak up on you.

Yeah. What strategies can I use to minimize taxes when converting? Should we be pairing these conversions with deductions? Yeah, I mean, most people use the standard deduction nowadays anyway. So again, my example of the couple with $150,000 income, they get a deduction first, right? So they're the 2025, it would be $30,000. So they're effective taxable basis, really only starting at 120. And then you add the Roth conversion on top of it. So you've got that standard deduction, maybe we use that available room. Other than that, if you itemize, again, you can sort of write that off against costs elsewhere, the income that you get to deduct does offset. Maybe if you've got large capital losses, that's a time to realize those and utilize some of that, although it doesn't wash like it would with a capital gain.

So be wary there. Also, you know, gray clouds, silver lining kind of thing. If the market does go down, and you have thought this through and are prepared ahead of time, then you may be able to take advantage of even a down market in converting over the same dollar value, but it represents a larger percentage of your overall account. Like let's just say that you were prepared to convert over $50,000 and you had $100,000 account and then the market went down. And so now your $100,000 account is 75,000, right? We were prepared to convert over 50%, but because the market's down, now we can convert over two thirds of the account value over to the Roth and then the recovery happens on the Roth side. So, you know, just pre-planning, being prepared, mapping these kinds of strategies out, not just for now, but into the future will allow people to do it more efficiently and expeditiously. Right. And it all comes back to having that plan. As you mentioned, Peter, if this, then that if the market goes down then, so this is great. I'm so glad we got to talk this through because I think a lot of people wonder when is the right time for a conversion?

The answer is it's going to depend on your, your unique situation as it often does. But if somebody wants to talk through it with you, how can they get ahold of you? Give me a call and we love to crunch these numbers and then bring into the conversation accountants that we work with, or if you work with an accountant or a CPA and we want to make sure that all T's are crossed and I's are dotted and we understand the full implications will, you know, correspond where we need to and communicate.

That's how you get the most out of your planning team. But give me a call. Nine one nine three zero zero five eight eight six.

Again, Peter Rashan, nine one nine three zero zero five eight eight six. And actually I do sometimes get the question, Aaron, you know, why isn't my accountant talking to me about this? Sometimes they do.

Sometimes they don't. But oftentimes these kind of proactive forward looking strategies are a little counter and conflicting with the, the, the job and mission of an accountant who's looking back at last year, trying to save you the most and bring down that tax bill. You know, ultimately taxes are pay me now or pay me later.

So sometimes paying now and paying ahead proactively reduces the lifetime tax bill, but it would bring the tax bill for this year up. And so we've got to reconcile that when we are making any of these Roth considerations. All right, Peter, thanks for your time today. Absolutely Aaron. Thank you. Hey folks, Peter Rashan here with Rashan Planning.

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