12% Roth Conversion

The 12% Roth Conversion

If you make less than $105,050, you’ve got to look into the 12% Roth Conversion. For a married couple, the 12% Federal Income tax rate goes all the way up to $80,250 for 2020. That’s taxable income. With a standard deduction of $24,800, a couple could make up to $105,050 and remain in the 12% bracket. Above those amounts, the tax rate jumps to 22%.

For those who are in the 12% bracket, consider converting part of your Traditional IRA to a Roth IRA each year. Convert only the amount which will keep you under the 12% limits. For example, if you have joint income of $60,000, you could convert up to $45,050 this year.

This will require paying some taxes today. But paying 12% now is a great deal. Once in the Roth, your money will be growing tax-free. There will be no Required Minimum Distributions on a Roth and your heirs can even inherit the Roth tax-free. Don’t forget that today’s tax rates are going to sunset after 2025 and the old rates will return. At 12%, a $45,050 Roth conversion would cost only $5,406 in additional taxes this year.

Take Advantage of the 12% Rate

If you have a large IRA or 401(k), the 12% rate is highly valuable. Use every year you can do a 12% Roth Conversion. Otherwise, you are going to have no control of your taxes once you begin RMDs. If you have eight years where you can convert $40,000 a year, that’s going to move $320,000 into a tax-free account. I have so many clients who don’t need their RMDs, but are forced to take those taxable distributions.

Here are some scenarios to consider where you might be in the 12% bracket:

  1. One spouse is laid off temporarily, on sabbatical, or taking care of young children. Use those lower income years to make a Roth Conversion. This could be at any age.
  2. One spouse has retired, the other is still working. If that gets you into the 12% bracket, make a conversion.
  3. Retiring in your 60’s? Hold off on Social Security so you can make Roth Conversions. Once you are 72, you will have both RMDs and Social Security. It is amazing how many people in their seventies are getting taxed on over $105,050 a year once they have SS and RMDs! These folks wish they had done Conversions earlier, because after 72 they are now in the 22% or 24% bracket.

Retiring Soon?

Considering retirement? Let’s say you will receive a $48,000 pension at age 65. (You are lucky to have such a pension – most workers do not!) For a married couple, that’s only $23,200 in taxable income after the standard deduction. Hold off on your Social Security and access your cash and bond holdings in a taxable account. Your Social Security benefit will grow by 8% each year. The 10 year Treasury is yielding 1.6% today. Spend the bonds and defer the Social Security.

Now you can convert $57,050 a year into your Roth from age 65 to 70. That will move $285,250 from your Traditional IRA to a Roth. Yes, that will be taxable at 12%. But at age 72, you will have a lower RMD – $11,142 less in just the first year.

When you do need the money after 72, you will be able to access your Roth tax-free. And at that age, with Social Security and RMDs, it’s possible you will now be in the 22% tax bracket. I have some clients in their seventies who are “making” over $250,000 a year and are now subject to the Medicare Surtax. Don’t think taxes go away when you stop working!

How to Convert

The key is to know when you are in the 12% bracket and calculate how much to convert to a Roth each year. The 12% bracket is a gift. Your taxes will never be lower than that, in my opinion. If you agree with that statement, you should be doing partial conversions each year. Whether that is $5,000 or $50,000, convert as much as you can in the 12% zone. You will need to be able to pay the taxes each year. You may want to increase your withholding at work or make quarterly estimated payments to avoid an underpayment penalty.

What if you accidentally convert too much and exceed the 12% limit? Don’t worry. It will have no impact on the taxes you pay up to the limit. If you exceed the bracket by $1,000, only that last $1,000 will be taxed at the higher 22% rate. Conversions are permanent. It used to be you could undo a conversion with a “recharacterization”, but that has been eliminated by the IRS.

While I’ve focused on folks in the 12% bracket, a Conversion can also be beneficial for those in the 22% bracket. The 22% bracket for a married couple is from $80,250 to $171,050 taxable income (2020). If you are going to be in the same bracket (or higher) in your seventies, then pre-paying the taxes today may still be a good idea. This will allow additional flexibility later by having lower RMDs. Plus, a 22% tax rate today might become 25% or higher after 2025! Better to pay 22% now on a lower amount than 25% later on an account which has grown.

A Roth Conversion is taxable in the year it occurs. In other words, you have to do it before December 31. A lot of tax professionals are not discussing Roth Conversions if they focus solely on minimizing your taxes paid in the previous year. But what if you want to minimize your taxes over the rest of your life? Consider each year you are eligible for a 12% Roth Conversion. Also, if you are working and in the 12% bracket, maybe you should be looking at the Roth 401(k) rather than the Traditional option.

Where to start? Contact me and we will go over your tax return, wage stubs, and your investment statements. From there, we can help you with your personalized Roth Conversion strategy.

5 Tax Savings Strategies for RMDs

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In November each year, we remind investors over age 70 1/2 to make sure they have taken their Required Minimum Distribution (RMD) from their retirement accounts before the end of the year.  If an investor does not need money from their IRAs, the distribution is often an unwanted taxable event.  Although we can’t do much about the RMD itself, we can find ways to reduce their taxes overall.

Clients who have after-tax contributions to retirement accounts often ask about which account they should take their RMDs, but it doesn’t matter.  The IRS considers IRA distributions to be pro-rata from all sources, regardless of the actual account you use to make the distribution. Whichever account you use to take the RMD, the tax due is going to be the same.

If all your contributions were pre-tax, your basis in all accounts is zero and you can ignore the comments above.  Note that you do not have to take a distribution from each individual account, even though each custodian is likely to send you calculations and reminders about your RMD for that account. All that matters is that your total distribution meets or exceeds the RMD for all accounts each year.

For investors taking RMDs, here are 5 steps you can take to reduce your income taxes:

1) Asset Location.   Avoid generating taxable income in your taxable accounts by moving taxable bonds, REITs, and other income generating investments to your retirement account.  This will keep the income from the investments out of a taxable account, leaving your RMD as your primary or only taxable event.  Placing stable, income investments in your IRA will also be a benefit because it will keep your IRA from having high growth.  Otherwise, if your IRA grows by 20%, your RMDs will grow by 20%.  (Actually more than 20%, since the percentage requirement increases each year with age).

Keeping stocks and ETFs in a taxable account allows you to choose when you want to harvest those gains and also allows you to receive favorable long-term capital gains treatment (15% or 20%), a tax benefit which is lost if those positions are held in an IRA.  Lastly, if you hold the stocks for life, your heirs may receive a step-up in basis, which is yet another reason to hold stocks in a taxable account and not your retirement account.

2) Charitable Donations.  If you itemize your tax return and are looking for more deductions, consider increasing your charitable donations.  And instead of giving a cash donation, donate shares of a highly appreciated stock or mutual fund and you will get both the charitable donation and you’ll avoid paying capital gains on the position later.

3) Stuff your deductions into one year.  Many investors in their 70’s have paid off their mortgage and it is often a “wash” between taking the standard deduction versus itemizing.  If this is the case, consider alternating years between taking the standard deduction and itemized deductions.  In the year you itemize, make two years of charitable donations and property taxes.  How do you do this?  Pay your property tax in January and the next one in December and you have put both payments into one tax year.  Do the same for your charitable contributions.  The following year, you will have few deductions to itemize and will take the standard deduction instead.

4) Harvest losses.  Investors are often reluctant to sell their losers, but selectively harvesting losses can save money at tax time.  Besides offsetting any capital gains, losses can be applied against ordinary income of up to $3,000 a year, and any leftover losses carry forward indefinitely.

5) Roth IRA.  If you don’t need your RMD because you are still working, consider funding a Roth IRA.  There is no age limit on a Roth IRA, so as long as you have earned income, you are eligible to contribute $6,500 per year.  If you qualify for a Roth, then your spouse would also be eligible to fund a Roth, even if he or she is not working.  Although the Roth is not tax deductible, the contribution does enable you to put money into a tax-free account, which will benefit you, your spouse, or your heirs in the future.

There is a “five year rule” which requires you to have a Roth open for five years before you can take tax-free withdrawals.  This rule applies even after age 59 1/2, so bear that in mind if you are establishing a Roth for the first time.

One additional suggestion: although you have until April 1 of the year after you turn 70 1/2 to take your first RMD, waiting until then will require you to have to take two RMDs in that year.  It may be preferable to take your first RMD in the year you turn 70 1/2, by December 31.