- One approach to help save on taxes is to do a so-called "focused conversion" of assets in an IRA.
- When you're in a lower tax bracket than usual, you may be in a better position to convert assets to a Roth IRA.
- Converting certain IRA assets to Roth IRA assets can help boost after-tax retirement income, and reduce future required minimum distributions (RMDs) at age 72, since RMDs do not apply to Roth IRAs.
While everyone's risk tolerance, retirement horizon, and lifestyles are different, most everyone is interested in saving money on taxes. If you are holding investments in a traditional IRA and you think you may be in a lower tax bracket this year than you might be in the future, then a "focused conversion" may be a strategy to consider. "Converting while your tax bracket is down temporarily is like shopping during a sales tax holiday—everything is cheaper," explains Mitch Pomerance, CFP®, CFA, a Fidelity advisor based in Danvers, Massachusetts. "But unlike the tax savings on buying a new outfit during a sales tax holiday, the benefits of converting while you're in a lower bracket compound year after year. It's like getting a tax break that grows over time."
When asset prices are down, this approach may allow you to pay less in taxes on the converted amount than you otherwise would. Over time, those savings, coupled with the power of compounded, tax-free growth in a Roth account may mean more retirement security, higher retirement income, and a larger legacy for you and your loved ones.
How a focused conversion works
A focused conversion is a financial planning technique that is designed to improve after-tax returns for investments in traditional IRAs. In a nutshell, it involves 4 steps:
- Waiting for a year in which the investor is in a lower tax bracket than usual
- Identifying 2 investments—one to be sold and another to be bought in its place
- Selling the first investment and converting the proceeds to a Roth IRA (paying for the cost of conversion using assets in a taxable account)
- Purchasing the second investment in the Roth IRA.
A hypothetical example
Meet Joyce. She's 73, retired, and files her taxes jointly with her spouse. She has a traditional IRA as well as several other accounts that total about $1,000,000. Last year, between required minimum distributions (RMDs) of $40,000, Social Security income of about $50,000 (for herself and her spouse), and income from an annuity, rental real estate, and other recurring sources of about $30,000, her total household income was around $120,000. This put her in the 22% federal income tax bracket, which in 2020 applies to taxable income (that is, income after all deductions, exemptions, and exclusions) of $80,250 to $171,050 for joint filers.
But this year, because she plans to skip her RMD as permitted under the CARES Act, Joyce's total household income will be considerably lower (and since she and her spouse won't be doing any travel this year, the reduced income won't be a problem).
As a result, after the standard deduction of $24,800 (plus $2,600 because of her and her spouse's age), her estimated income this year should put her in the 12% bracket (taxable income of $19,750 to $80,250 in 2020). After this year, with the resumption of RMDs, she expects her tax bracket to return to 22%.
Looking for opportunities to rebalance
Joyce holds a variety of funds in her traditional IRA, and she rebalances it regularly in order to stay as close as possible to her targeted asset allocation. Because of a recent decline in interest rates, Joyce's portfolio is out of balance: Her fixed income allocation is too high and her equity allocation is too low, based on the objectives of her financial plan.
With a rebalancing strategy in mind, Joyce plans to place a number of trades, including a sale of $10,000 of a hypothetical Bond Fund ABC and a purchase of $10,000 of a hypothetical Equity Fund XYZ. Joyce also has $1,200 currently in cash in a brokerage account, which unlike her IRA does not have a specific targeted asset allocation and is not rebalanced regularly. She thinks of the brokerage account as her "play money" and sometimes uses it to speculate in individual stocks. But since Joyce is anticipating a broadly rising market for equities, rather than buying individual stocks, she is inclined to invest her brokerage account money in XYZ as well. She is considering 2 options:
- A conventional rebalancing trade. She would sell $10,000 of Bond Fund ABC and buy $10,000 of Equity Fund XYZ in her traditional IRA. Let's assume, for purposes of the illustration, that she would then use her brokerage account to buy $1,200 more of XYZ in her traditional IRA.
- A focused conversion. She would sell $10,000 of ABC in her traditional IRA but then convert this amount to a Roth IRA, and purchase $10,000 in XYZ shares in her Roth IRA. (Note that Joyce considers the Roth IRA and the traditional IRA as a single portfolio for asset allocation purposes.) This trade would cost her $1,200 (or $10,000 times 12%, her 2020 marginal tax rate) in current year tax cost, and she would cover this using the cash in her brokerage account.
At first blush, if the equity market does rally, one might think Option 1 would be better than Option 2. After all, Option 1 would allow Joyce to buy a total of $11,200 of XYZ rather than just $10,000. But let's consider what would happen if, in a highly simplified and purely hypothetical example, the market does very well, and 10 years from now a $10,000 investment in XYZ has tripled and so is worth $30,000 (implying a compound annual return of 11.61%). Given the same growth, the brokerage account investment would have reached $3,600. And let's assume around that time, Joyce would withdraw and spend the assets.
Even though it starts with a smaller investment in XYZ, Option 2 would leave Joyce with $3,360 more than Option 1—an improvement of more than 12.5%. Why? Because while Option 1 does allow Joyce to purchase more of XYZ, it also leaves her with a tax bill that's so much higher, resulting in her giving back all the additional gains—and then some.
10 years out: The potential impact of dividends and capital gains
What if XYZ made dividend or capital gain distributions along the way, as many equity funds do? The after-tax value of the investment in the brokerage account would effectively be somewhat less than the $3,240 assumed here because those distributions would be taxed. So in fact, the benefit from conversion would probably be somewhat larger than $3,360. What if the some of the withdrawals took place not in year 10, but later? There would be additional growth, and the benefit of conversion would also be larger.
Conversely, what if the equity markets do not perform well, and the XYZ IRA investments end up being worth $10,000—the same as today? It turns out Joyce would still be better off under Option 2 in this scenario.
Nevertheless, when it comes to financial planning, there are details that can make things a bit more complicated. In our first scenario, since the value of her investment in XYZ triples, Joyce may need to rebalance again, so she might not be able to keep all of her investment in XYZ. That could reduce the size of the advantage of Option 2.
"Remember, a focused conversion isn't foolproof," says Pomerance. "It's possible that a future reduction in tax rates or some other change in tax law could mean that the benefits of focused conversion could be reduced or even eliminated. The overall goal for most people doing a focused conversion would be that their future taxable income could be lowered."
Bumping up against net investment income thresholds
In addition, there are several other factors that could make focused conversion even more attractive. For example, qualified distributions from a Roth IRA are not counted for purposes of figuring the taxation of Social Security benefits, which might be an important additional benefit for those with lower incomes than Joyce. For those with higher incomes, this strategy may help keep income levels below certain thresholds, which could reduce Medicare premiums (sometimes referred to as the income-related monthly adjustment amount, or IRMAA) and/or the 3.8% Medicare surcharge (see chart). Finally, Roth IRAs aren't subject to RMDs during the original owner's lifetime, so Roth conversion may also help investors avoid taking IRA withdrawals (and generating tax liability) that they don't need.
Since the details can make a difference in determining taxes paid over a number of years, it's a good idea to consult with a tax advisor or a financial professional before implementing a focused conversion. That can help make sure that you've considered all the possibilities and that the strategy fits into your broader financial plan.
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