Part 1 of 3
We are well into the second half of the year in 2019 which means it is time to start thinking about what year end planning needs to be done. There are some VERY popular strategies that have come from the new tax code but they need to be BEFORE year-end.
In Part 1 we will discuss why Roth Conversions have become increasingly popular as a result of the new tax code that is now over a year old and we only have 6 tax years left on it. Let’s take a closer look to see why a Roth Conversion might be a perfect strategy with this tax code.
A Roth conversion is when someone takes money from their pre-tax account (IRA, 401(k), etc.) and moves it to their after-tax Roth IRA account. Once converted the earnings in the Roth IRA grow tax free for the remainder of the holder’s life as long as the Roth has been open for 5 years and they are over 59 ½ before the earnings are first withdrawn.
When to Start
The best time to do the conversions is during what we call the Roth conversion sweet spot window, between the ages of 65-70. At these ages the owners are typically on Medicare, so they don’t have to worry about excess income affecting health premiums, and also they are not at the point where they are required to draw funds from their IRA account which happens when you turn 70 ½ years old.
The new tax code has made the Roth conversions advantageous in two ways. The first being that the tax rates at the 12% and 22% bracket were lowered by 3% each compared to prior years. Secondly, the standard deduction is larger allowing one to stay in these lower tax rates longer…allowing more income to be realized at the lower rate.
How Much to Convert
As for how much you should take, we suggest maxing out the above-mentioned tax bracket you are in. For example, if you have room to take income of another $20,000 and only pay 12% federal tax on it before going into the 22% bracket, we would strongly suggest considering that.
What if I Wait?
If you wait to tap into your pre-tax account until required at 70 ½ you can find out that the account has grown to a point where the distribution could push you up into a new tax bracket! So, where you could have drawn (or converted) at 12%, you are now forced to pay at 22%. Not to mention this higher income can increase your Medicare premiums and increase the amount of taxes you pay on your Social Security…whoa triple whammy!
Remember the pre-tax funds that you and your spouse do not use will likely go the next generation who may still be working. They will be required to take income from these accounts each year and when combined with their current earnings could likely pay taxes well in excess of the 22% bracket. However, if they inherit a Roth IRA the balance will all be tax free income to them.
Keep in mind that this tax code is not permanent. The time to do Roth conversions at lower rates and with a higher standard deduction is now. There are 6 years left on it, tax advantage of it while it is available.