Roth Conversion Planning Process for 2022

If you had the choice … Would you pay sales price or full price? We all like finding a good deal. This is what makes Roth Conversion planning so great.

Roth Conversion planning is all about finding tax rates that are on sale.

A Partnership with the Government

Saving money into a retirement account is usually a good idea. The US Government agrees and provides an incentive for saving money into retirement accounts.

The most common incentive is to let you deposit money into the account without paying tax. They even sweeten the pot to let that money grow tax-free.

Like any good deal there are strings attached. Since you didn’t have to pay tax when you deposited money into the account, you are required to recognize withdrawals from the account as taxable income.

By using these accounts you’re in a partnership with the government.

They let you make tax-free deposits and allow the money to grow tax-free. At some point they want to get paid their fair share just like any other partnership.

To ensure they get paid, they created a few rules around WHEN you need to take withdrawals. By forcing you to take withdrawals they will eventually get paid their fair share.

There are two rules on when you take money out of the account.

1. You have to start annual distributions at age 72 (i.e. Required Minimum Distributions)
2. Your non-spouse beneficiaries have up to 10 years after you die (i.e. IRA Beneficiary rules)

These are the rules to ensure they are paid their fair share.

One cool thing about this partnership is that you don’t have to do what’s in your partner’s best interest prior to the forced distribution dates.

You are restricted from taking a straight withdrawal from the account based on your age or other circumstances. This is because your partner believes the money should be used for retirement. Yet, they do provide some exceptions if you run into a hardship.

Where they give you flexibility is with Roth Conversion planning. Roth Conversion planning lets you take money out of the account without running afoul of the early withdrawal rules.

Roth Conversions can be done in any amount, any age, or under any circumstance.

Smart Roth Conversion planning is all about timing your tax payment. Paying less tax by finding when your tax rates are on sale.

A Roth Conversion should help you pay less tax

Smart Roth Conversion planning is the ticket to paying less tax with your retirement accounts.

Strategic use of Roth Conversions is your way to pay your partner less.

How do you effectively complete a smart Roth Conversion? By understanding Tax Bracket Management. Tax Bracket Management and Roth Conversion planning are intertwined.

Without understanding Tax Bracket Management, you lack the skill to successfully complete smart Roth Conversions.

What makes Roth Conversion planning difficult

Understanding what makes a smart Roth Conversion is easy. Complete a Roth Conversion when tax rates are low.

The mechanics of a Roth Conversion is simple.

What makes Roth Conversion planning difficult is confidently identifying what qualifies as a low tax rate.

A low tax rate differs per person. You need to run the numbers. Sorry. There isn’t any one size fits all answer here.

How do you know what’s a low rate for your situation?

Ideally you’ll have a crystal ball that eliminates the uncertainty of the future.

Assuming you don’t have one or it’s cloudy then here are two questions to ask:

1. What is the direction of tax policy?
2. What is the impact of your tax facts on your future tax rate?

Oh man… a crystal ball would really help with the first question.

What is the direction of tax policy?

The general belief is that the current tax rate environment (2018-2025) is favorable. Some believe the lowest we’ll see in our lifetimes.

The current US deficit implies we have to raise taxes. Modern Monetary Theory (MMT) does contradict that idea so taxes may not go up to fund the deficit. Yet, MMT does indicate taxes could go up for wealth redistribution purposes.

Whatever future you want to believe in both point towards higher taxes. We just don’t know in what form or to whom.

If you have a strong belief in where tax policy is going… then that matters. Your belief in tax policy is important to confidently completing a smart Roth Conversion.

Don’t complete a Roth Conversion if you think you’ll pay more tax today then you would tomorrow!

Yet, we always have to remember… the future is unknowable.

When you might find certainty that your Roth Conversion is completed at a low tax rate

While we can never know the future ahead of time, there are occasions where we can be confident today’s tax rate is lower than tomorrow’s.

We should all be able to agree that completing a Roth Conversion at a 0% federal tax rate is a good deal. Even if you complete a Roth Conversion at a 0% tax rate today and then fall into a 0% tax rate tomorrow… it’s going to be OK.

Can you pay a 0% tax rate?

Yes.

I see many opportunities to pay a 0% tax rate on a small Roth Conversion all the time.

The biggest Roth Conversion of my career was converting 80% of the client’s IRA to a Roth to match a huge Net Operating Loss. Yup… the client paid a 0% federal tax rate on about $800,000 of her IRA. Unfortunately, the rules have changed with Net Operating Losses since then so it’s unlikely it will ever happen again.

That’s an uncommon example.

It’s more common with early retirees who don’t take advantage of paying a 0% federal tax rate.

How is this possible?

Taxes in retirement are significantly different than while working. Retirees often have NEGATIVE ordinary income. Yeah you read that right. NEGATIVE ORDINARY INCOME.

Every time I see a new tax return with this irresponsible outcome, I cry a little bit inside. Even if they don’t want to convert, I bet they would LOVE a tax-free distribution. Ugh.

For everybody else your Roth Conversion will likely cost more than a 0% federal tax rate.

This is where you need to know your facts and understand Tax Bracket Management.

Know your facts so you pay less tax

At this point you’re in touch with your feelings on the future of tax policy. If not…go with your gut and move on.

The next step is to understand how your facts under the current tax law impact your tax.

Here is what you need to know about current tax law:

• Current tax law (Tax Cuts and Jobs Act – TCJA) became law in 2018
• The TCJA is set to sunset in 2026
• When it sunsets it will revert back to the 2017 tax law

Here is a comparison chart:

There are talks about tax reform under the Biden administration. As of this article there aren’t much details. However, what we do know is that there may be changes to portions of the current law. There will not be a complete overhaul of the current tax law.

Experts believe that we will see the current tax law change a little in 2022 and revert back to 2017 rules in 2026.

If we see tax rates revert back to 2017 tax law, then we will see a tax rate increase.

Next, you need to understand your facts:

• You’re required to take distributions at age 72 from tax-deferred retirement accounts
• At age 70 you HAVE to start taking Social Security income, if you’re eligible for it

When you reach age 72, you will lack control over your taxable income.

Prior to age 70 many retirees have control over your taxable income. This is because many retirees have multiple buckets to use for cash flow in retirement.

This loss of control after age 70 often takes retirees to their highest tax brackets.

These are the critical ingredients in determining if you complete a Roth Conversion at a low tax rate.

Your projected tax bracket after age 70 is a common benchmark for knowing when a Roth Conversion is done at a low tax rate.

It asks the question… Will our Roth Conversion cost less than the future cost of RMDs?

This is what I call your Tax Bracket Target.

Roth Conversion up to your Tax Bracket Target

At this point you know two things:

1. You want to convert to a Roth whenever tax rates are on sale
2. You need to find your benchmark by identifying how your tax facts affect your future tax

The next step is to quantify a Roth Conversion that is up to or below your benchmark.

• If you convert up to your benchmark, you’re focused on “tax diversification.”
• If you convert below your benchmark, you’re focused on “tax bracket arbitrage.”

Your path determines your Tax Bracket Target.

Calculating your actual Roth Conversion is the most important step in the process. Messing up this step makes everything else a waste of time and possibly money.

Unfortunately, this step causes more pain and confusion than anything else.

Everybody understands that paying less tax today is better than paying more tax tomorrow.

Where the wheels falls off is when comparing today’s tax rate against the benchmark tax rate.

The problem isn’t with the benchmark tax rate. Most people believe taxes are going up and understand the 2017 tax law is a tax rate increase, especially when it’s driven by their tax facts.

The real problem… calculating the Roth Conversion amount to reach your Tax Bracket Target.

To reach your Tax Bracket Target you must know Tax Bracket Management.

What makes tax bracket management so difficult?

Awareness.

Lack of awareness of how tax brackets flow together.

This lack of awareness happens when you find line 15 (taxable income) on your Form 1040 and then match that number to the marginal tax brackets. That’s not how it always works!

If the tax return doesn’t have any dividends or capital gains then this can work. This isn’t the norm for retirees so you need to run the numbers.

You don’t need to be a CPA, EA, or CFP to be learn Tax Bracket Management. Anyone can learn the basics of Tax Bracket Management.

If you’re already a tax planner then get start for free with the Tax Bracket Manager Free. After you enter the data from your tax return look at the Bracket Breakdown to see your actual tax bracket.

Slow down and make a smart Roth Conversion

Roth Conversion planning isn’t a sprint.

You should only do it if you understand the long-term value.

Most Roth Conversions are incremental Roth Conversions. Roth Conversions can be done opportunistically and for hedging against an unknowable future.

It’s rare that conversions are a large percentage of the IRA in one year.

Develop a big picture plan. Then convert when tax rates are on sale for you.

Pay less tax. Keep more of your nest egg.