Using Roth Conversions to Reduce Lifetime Taxes Paid
You reduce your lifetime taxes paid through leveling your lifetime tax liability.
Consider your lifetime of paying taxes:
There are years where you likely earned more income (say at the 32% marginal bracket) & less income in other years (say the 12% marginal bracket) - with an average effective tax rate of 21%.
The years you paid 32% of you overpaid in taxes by 11%.
The years you paid 12% you underpaid in taxes by 9%.
Instead of getting excited when you have a low tax year or upset when you have a high tax year - you should take a step back and consider strategies to deploy to ensure you’re getting as close to 21% (or your targeted effective tax rate).
Consider the graph above, this is an example of a lifetime of projected tax liability.
Looking at your earning growth potential from 2024 to 2054, we see rising taxes associated with the expectation of rising income.
Retirement starts in 2059 then required minimum distributions begin in the year 2068.
Looking at this projection the lifetime effective tax rate is 26.69%, you can see at a high level how you would want to pay tax in some years (2024 - 2040) then defer income (2041 - 2058), then accelerate your tax bill (2059 - 2068).
Goal being:
When you’re below that average effective tax rate, you should be looking for ways to accelerate your taxes paid.
When you’re above that average effective tax rate, you should be looking for ways to reduce your taxes paid.
One effective way to accelerate your taxes paid is through Roth conversions.
A Roth conversion is where you would take pre-tax (traditional) dollars and convert them to after-tax (Roth) dollar.
In the process of converting pre-tax dollars to post-tax dollars, you pay tax on the amount of the conversion in the year you make the conversion but then are not taxed again.
Unlike the ability to contribute to a Roth IRA (which is limited based on income), your ability to convert pre-tax to post-tax is not limited by your income.
While we don’t know what future tax rates will be, we do know what current tax rates will be & we can plan based on what numbers we have available to us today.
With that in mind, at the making of this blog in February of 2024, Trump’s Tax Cuts & Job’s Act reduced individual tax rates which is set to revert back to prior tax rates beginning in 2026.
So, if nothing changes, tax rates in 2026 & beyond will be higher than they are today.
Also - if you’d allow me to speculate… 2020 stimulus spending was in the trillions of dollars which would lend itself to suggesting future tax rates may increase to help pay for all that spending.
Which today, may imply that it could be a good time to pay tax (if that’s something that makes sense for you).
At a minimum, diversifying the taxation of your assets will provide you both choice and flexibility regarding when & how you want to pay tax (this is through having taxable, tax-deferred, and tax-free buckets of savings).
If you’re someone who is only making pre-tax contributions throughout your life, you’re basically giving your future self a tax bomb.
Why?
Because every dollar pulled out of pre-tax accounts are taxed at whatever current ordinary tax rates are.
Having flexibility in withdrawal options in retirement can also help avoid common hidden taxes, such as:
More of your social security being taxable (which is based on provisional income where either 0%, 50%, or 85% of your social security benefit is taxable)
Having income above 4x the federal poverty line based on family size & losing the premium tax credit (if under 65)
Medicare surcharges known as IRMAA (if over 65)
Increasing capital gains tax from 0% to 15% or 20% (even potentially introducing a 3.8% net investment income tax)
One other benefit of Roth accounts is that when you die, your beneficiaries will not be subject to income tax when they inherit Roth assets for you (if you’re looking to reduce your generational lifetime tax liability, you could consider their expected future marginal tax rate to determine whether it would be more beneficial for them to pay the tax opposed to you - but I’ll digress).
When a Roth conversion likely makes the most sense is after you stop working but before:
You start taking withdrawals from your tax-deferred accounts
Receive social security, pensions, or annuity income
Enter a low historical income year (relative to your lifetime projected effective tax rate)
Roth conversion benefits can further be optimized by completing a conversion when there are depressed market prices (but wouldn’t be a strong enough stand-alone reason to make a Roth conversion).
Rational being:
Scenario 1: You convert $10,000 at an average price of $10/share, you convert 1,000 shares.
Scenario 2: You convert $10,000 at an average price of $8/share (20% price reduction), you convert 1,250 shares.
Then when prices rebound to prior levels, you’ll have more income that you can access tax-free.
When you complete a Roth conversion, there are a couple things to be mindful of:
Having enough cash on hand to pay the tax bill associated with the conversion. If you’re converting $50,000 at an average tax rate of 18%, this could mean that you’ll need $9,000 come tax time to pay that federal tax bill (plus your state tax rates, if applicable)
Being mindful of your federal tax bracket. Tax brackets currently range from 10, 12%. 22%, 24%, 32% and 37%, if you’re looking to convert up to the max of the 24% bracket but spill over into the 32% bracket, you’ll pay an extra 10% in taxes on the dollars that exceed the 24% bracket.
Roth conversions are irreversible - so once you’ve completed the conversion you can’t rectify it on the back end. If you’re unsure on how much to convert, either work with a professional or convert less than you think you should.
Be mindful of qualified Roth distributions. For your earnings to be tax-free be mindful of the 5-year rule and attaining age 59.5.
Roth conversions are easily one of my favorite tax planning tools to reduce lifetime tax liability - but should be evaluated carefully to ensure you don’t pay any more tax than you should.