With the 2020 elections wrapping up, investors are now faced with the financial planning implications of an entirely blue federal government. In other words, what are the chances the Tax Cuts and Jobs Act (TCJA) of 2017 is entirely or partially undone and investors are faced with tax hikes in 2021 or 2022? We feel it is prudent to begin the planning process quickly once the prospects of higher taxes are on the table. While the TCJA of 2017 was forward-looking (i.e. new tax laws apply for FY 2018 and ignore 2017), some tax laws in the past have been both passed and implemented in the same year. Below is a short list of major tax laws since the “Reagan tax cuts” in 1986 and the year they were implemented.
One strategy that is popular when an investor is anticipating higher taxes in the future is a Roth conversion strategy. A Roth IRA is an investment vehicle that allows tax-free growth and distribution of investments. This contrasts with a traditional IRA, which allows tax-deferred growth of investments and then taxable distributions later.
In a Roth conversion strategy, the investor lowers the size of required minimum distributions (RMDs) from traditional IRAs in later years when taxes may be higher, by taking distributions sooner in a year with a lower tax bracket. While you can’t outright avoid paying the taxes (because Uncle Sam always wants his piece of your pie), the IRS lets you control when the taxation of your capital occurs.
Here are three common questions investors ask concerning Roth conversions.
1. How am I taxed on a Roth conversion?
Roth IRAs are taxed like any other distribution from a traditional IRA. In general, this means you will face ordinary income taxes on the distributions. Because we have a progressive income tax system, your taxes will be marginally higher as you increase the conversion amount.
There are two options to pay taxes when converting capital from a traditional IRA to a Roth IRA: 1) withhold taxes from your traditional IRA, or 2) choose not to withhold taxes and sort taxes out when filing annual tax return. In almost all cases, the second choice is the optimal option. By choosing the former, you will owe taxes on the amount you withhold to pay the conversion taxes, and there will be a penalty if you are still under age 59 ½. Additionally, the first strategy lowers the amount of dollars that can be put into the Roth IRA.
2. Are there dollar limits on Roth conversions?
There are no set dollar limits on how much of your traditional IRA is convertible to a Roth IRA. Rather, the conversion amounts become self-restricting as your marginal dollar is taxed at higher rates. The higher the marginal tax rate, the less investors are incentivized to convert capital from traditional IRAs to Roth IRAs. We recommend Roth conversions when clients are below the 12% tax bracket.
3. How do I know the optimal amount to convert from a traditional IRA to a Roth?
Because there is no set dollar limit, it can become frustrating to estimate the appropriate dollar amount to convert. We can anticipate higher taxes in the future, but without a crystal ball that knows the exact amount taxes will be higher, all we are left with are estimates. This is where working with a financial planner becomes important, as we can help investors use their risk tolerances and time horizons to determine the impact of various Roth conversion strategies on their overall plan and goals.
Christopher Lloyd, CFP®, AAMS®
Vice President and
Senior Wealth Planner
Christopher Lloyd, CFP®, is a Vice President, Senior Wealth Planner, Portfolio Manager and Co-Founder of Lloyds Intrepid Wealth Management. Since 2014, he has held positions as an analyst, trader, wealth planner and business developer, while working at Chilton Capital Management, Merrill Lynch and Lloyds Intrepid Wealth Management. For a complete resumé, visit his profile at LinkedIn.
Chris holds a BS in Economics from Texas A&M University.
Chris is a Certified Financial Planner™ certificant.
Lloyds Intrepid LLC is doing business as Lloyds Intrepid Wealth Management. Lloyds Intrepid LLC offers investment advisory services in the State of Texas where registered and in other jurisdictions where exempted. Registration does not imply a certain level of skill or training. Lloyds Intrepid LLC and its advisers do not provide legal, tax or accounting advice. Lloyds Intrepid LLC formulates retirement plans, investment strategies, portfolio construction and investment due diligence for clients with signed investment advisory agreements with us. The information contained herein has been obtained from sources believed to be reliable, but the accuracy of the information cannot be guaranteed. All opinions and outlooks are subject to change.
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