Whether a sabbatical, a return to graduate school, an entrepreneurial pursuit, or simply a period of unemployment, many of us have years in the middle of our career where our incomes take a dip.
While there are a lot of financial implications during this period of low income, there can be tax benefits to those who plan accordingly. Specifically, our favorite strategy that we recommend to clients is the Roth conversion.
We’ll explain in this article who can benefit from a Roth conversion and how to go about doing it.
What is a Roth Conversion?
Let’s start with the basics. A Roth conversion entails transferring assets from a ‘Traditional’ 401(k) or IRA into a Roth.
Funds that are in a ‘Traditional’ 401(k) or IRA were contributed pre-tax, meaning you never paid income taxes on the money in that account. It grows tax-free, however, when you reach retirement and begin making withdrawals, all distributions are treated as taxable income.
On the other hand, the Roth 401(k) and Roth IRA do not provide an initial tax deduction. That means you contribute after-tax dollars. The funds then grow tax-free and distributions when in retirement are not taxable either. So, the beauty of the Roth account is that you put in after-tax dollars today, and never pay taxes on it again. Add in the fact that you do not have take a required minimum distribution at age 70 (like with a traditional IRA) and the ROTH is a no brainer. (If you couldn’t tell, contributing to a Roth account is actually one of our favorite lesser-known tax strategies.)
A Roth conversion is when you move funds from a Traditional retirement account to a Roth. The full market value amount of the transfer is considered income in the tax year that the conversion occurs.
Wait, a conversion increases my taxable income this year?
Correct, and as a result, this tax strategy actually might increase your taxes owed this year.
So, why would you do this?
Well, since all the funds are now in a Roth account, it will never be taxed again. It grows tax free and is available to you in retirement without having to pay any further taxes.
Plus, if you are in a low tax bracket this year, then the tax hit today might not be very significant. This is essentially a tax rate arbitrage strategy. You’re paying income taxes now when you are in a low bracket to avoid paying taxes in retirement when you’re likely in a higher bracket (due to income streams such as investment income and social security).
Who should consider this strategy?
Anyone whose income is taking a significant dip should consider this strategy. Of course, a prerequisite is that you need to already have a Traditional 401(k) or IRA account. Many people who have worked for a couple years will have contributed to their company’s 401(k) plan, and the most commonly used type is the Traditional. So there’s a good chance the Roth conversion can work for you.
The result is graduate students are often very well suited for this strategy. MBA students, for example, typically work for a few years before enrolling, thus are likely to have already set aside some money in a Traditional 401(k). Their wage income drops for the two years they are in school, putting them in a low tax bracket for likely the last time in their lives. This all combines to make them ideal candidates.
People that go on sabbatical, entrepreneurs that are building up their own companies, or those that simply find themselves unemployed might all benefit from this strategy. It’s worth evaluating if you find yourself in one of these situations.
Does this still apply following the new tax law enacted for 2018?
Yes, the new tax law does not affect your ability to do a Roth conversion. However, the law did introduce one new rule: no more recharacterizations.
Prior to 2018, a Roth conversion could be recharacterized. What that means is, after converting a Traditional 401(k) or IRA to a Roth, you previously had 12 months to reverse that decision and move the funds back to the Traditional account.
Why would someone do this? Typically, a recharacterization would be beneficial if the stock market runs into a rough patch shortly after the conversion. That’s because the market value at the time of the conversion counts as taxable income, which isn’t ideal if the account value drops significantly soon after.
For any Roth conversions occurring after January 1, 2018, recharacterizations are no longer possible. That means this strategy could lose some of its tax benefit if the stock market falls shortly after the conversion.
If you think you are a good candidate for a Roth conversion, reach out to a Visor tax advisor today to review the specifics. We work with clients to help evaluate the pros and cons based on their specific tax and financial circumstances.
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