End-of-Year tax planning: Roth conversion 101

[Michael Plaks]

I just finished EOY tax planning sessions with my clients, and Roth conversion was one of the topics. It reminded me how confused most investors are about Roth and prompted me to write this long post. Since Roth-related issues vary from very basic to very complicated, so will my post.

1. What is Roth IRA

It is not some other kind of retirement account. For example, 401(k) and IRA are two very different kinds of retirement accounts. However, Roth IRA is just an IRA. It works exactly the same way as a traditional IRA:

• you can contribute money into it every year, up to $6,000 (the limit changes from year to year and depends on your age)
• the account always belongs to one person, so husband and wife will have separate IRAs
• while your IRA money is invested and growing, you pay no taxes on your investments
• if you try to take the IRA money out before you turn 60 (well, 59 1/2 if we want to be exact), you usually pay a 10% penalty, with some exceptions
• your IRA can be self-directed, which allows you to invest in businesses and real estate and not just stocks and mutual funds

Everything above applies to both traditional IRAs or Roth IRAs. Their only critical difference is in how they are taxed.

2. Roth IRA v Traditional IRA taxation

Traditional IRA. You put $6,000 money into your IRA today. You deduct (usually, but not always) this $6,000 from your current year's income. As a result, you pay less taxes for this year. You invest this $6,000 into something, and 20 years later it becomes $20,000. During your retirement, you take this $20,000 out. When you take it out, it becomes taxable income to you. Thus you will eventually pay taxes on the entire $20,000.

Roth IRA. You put $6,000 money into your Roth IRA today. You do NOT get to deduct this $6,000 from your current year's income. As a result, your taxes for this year are not affected. You invest this $6,000 into something, and 20 years later it becomes $20,000. During your retirement, you take this $20,000 out. As you take it out, you owe absolutely no taxes. You will eventually take out the entire $20,000 tax-free.

To recap:
With traditional IRAs, you do NOT pay taxes on $6,000 now, but you will pay taxes on $20,000 in retirement.
With Roth IRAs, you do pay taxes on $6,000 now, but you will NOT pay taxes on $20,000 in retirement.

3. Is Roth IRA really superior?

Many financial planners and CPAs make this conversation focus on future tax rates vs. today's tax rates. They often assume (incorrectly, in my opinion) that you will need less annual income in retirement than you need today. If so, then your tax bracket in retirement should be lower, so you're better off paying taxes in retirement than today. Roth wins.

Then, there's this common notion that financial planners are missing the point, and that Roth is infinitely superior to traditional. Here's how this argument goes: if your $10k investment turns into $100k - who cares what the tax rates are? You are always better off paying taxes on $10k than on $100k, regardless of rates and regardless of when.

Who is right? Both. The trick is to compare apples to apples. Roth was designed to be equivalent to traditional, and it actually is! - as long as taxes are taken out of retirement money. 

Example. Let's consider a $10k investment that grows tenfold while inside an IRA for many years. (No relation to the 10X crap from you know who.) Let's assume 20% tax rate for simplicity.

Traditional IRA. No taxes now, so you invest the entire $10k. It becomes $100k. You have to pay $20k in taxes and are left with $80k.
Roth IRA. You pay $2k in taxes now and have $8k left to invest. It becomes $80k. No taxes to pay, so you take the entire $80k out.

See how both roads take you to the same place?

In reality, this is not how we behave or think. We do not subtract $2k in taxes from our $10k contribution. We pay the $2k tax from some other money, and we still contribute the full $10k. And then, we end up with $100k of tax-free money instead of $80k of tax-free money. Huge win for the Roth, it seems.

Basically, we're cheating, and it's not apples to apples. We are really investing $12k into Roth, not $10k. No surprise that Roth wins by a mile when we give it an initial boost in form of pre-paying taxes.

That said, if you have extra money to pay the tax upfront, and you're then choosing between $10k into a Traditional and $10k into a Roth - then surely it should be Roth.

4. Roth conversion

You're allowed to convert your existing traditional IRA accounts into Roth accounts. Under current tax law, you can do it for any amount and at any time.

Example. Years back, you twice contributed $5k into your traditional IRA, $10k total. By now, this account slowly grew into $15k because you kept it in relatively safe investments with modest growth. You're ready to make your IRA self-directed and start aggressively investing it in real estate notes and options. In couple years, you expect it to become at least $100k, maybe more.

You convert it into a Roth IRA now. You will owe taxes on $15k of extra income this year. However, in the future, when this account mushrooms into $100k, $500k or $10M - the money will stay tax-free forever. The only catch: you will owe taxes on $15k now.

Re-read my discussion of #3 above. If the taxes due on this $15k were to come out of the $15k itself - you would not gain any long-term advantage. However, nobody takes money out of the converted $15k account. (By the way, you would be subject to a 10% penalty if you do.) You would pay the tax from you other money, effectively subsidizing your retirement indirectly. So, if you have the cash for taxes - it's usually a good move.

The remaining question is when to do it. Now, in December, or wait until January? Here is how you decide.

• if your income this year was lower than usual, maybe due to Covid, then you want to convert in December, so the income from conversion is taxed at this year's lower bracket
• if you plan to quit your W2 job next year, then maybe your next year's income is likely to be lower. Then it's probably best to wait and have your Roth conversion taxed at the lower rate of next year
• if you plan to double your business next year - convert now and use this year's rate
• if you believe that the new administration will increase tax rates for next year - convert now to lock into today's rates
• if you expect to not have the cash for the extra tax - maybe wait

And remember that you can split the conversion: do some of it this year, and the rest of it later. Of course, this assumes you can predict the future. More on that below.

Important warning: all of the discussions so far assumed that your traditional IRA accounts contained only deductible contributions. In other words, every time you contributed to your IRAs in the past, you took a matching deduction on your taxes. This is not always the case, however. If your IRAs had any non-deductible contributions, Roth conversion (and your IRA taxation in general) becomes much more complicated. Don't DIY it, get professional help. Ditto if you're not sure whether or not your IRA contributions were deductible.

The above warning also applies to the so-called "backdoor Roth contributions" when you have any non-deductible money in any of your traditional IRA accounts. If you don't know what this means, it probably does not apply to you.

5. Is Roth for IRAs only?

No, you can also have a Roth 401(k), and it works basically the same way. If your employer offers you a Roth 401(k) option, take it. If you have your own Solo 401(k), consider turning it into a Roth 401(k). Both ways, you will have to pay more taxes today, but it will pay off eventually.

If your plan allows it (not all of them do), consider converting your existing 401(k) balance into Roth 401(k). You will owe taxes on the conversion, the same as we discussed for Roth IRA conversion.

6. About the future.

Some of y'all believe we have no future. Assuming that we still do, remember that everything we discussed depends on what happens in the future. As 2020 showed us, we should not overestimate our forecasting abilities. 

Let's start with the biggest risk of all: will the Roth concept survive? See, currently Roth has no limits on tax-free distributions. Whether you grow your Roth account into $50k or $50M - all of it is tax-free at withdrawal under today's tax law. Especially with self-directed IRAs, your retirement money can grow dramatically. The bigger your Roth account gets, the more you will love the tax-free distributions from it. 

In case you live under the rock, such "tax loopholes for the rich" have been under attack for a very long time. With the Democrats taking over and the overall social trends, I expect these attacks to intensify and eventually succeed. Roth is unlikely to die, but it could be substantially handicapped by future legislation. I think it's possible that we will see some kind of phased-in taxes on Roth distributions once they exceed certain thresholds. I want to be wrong on this particular prediction, but what if I'm right?

The already mentioned administration change brings with it a serious threat of an overall increase of tax rates, especially in the higher income zone. How much of that will Joe Biden be able to implement and how soon is anybody's guess. If you guessed "zero" and "never" - I suggest you guess again.

Besides a promise to raise tax rates, Biden's initial tax plan includes other proposals to revise the current retirement savings system. One of his proposals is rather fundamental: to replace current deductibility of pre-tax IRA and 401(k) contributions with refundable credits. If you recall the history of the 2017 Trump tax reform, campaign promises and early proposals had very little to do with the eventual tax law changes. As of today, I do not consider any of Biden's tax ideas a reliable indication of the future tax law, but who can tell. This entire post might become obsolete one year from now.

However, it's not my post I worry about. Your retirement plan may become if not obsolete, then at least substantially affected. 

For those of you who are already certain about our future - keep stocking up on ammo and toilet paper. Unfortunately, can't buy it with your IRA money, even if self-directed.