CKBlog: Financial Planning

Thursday, December 10, 2020

COVID Conversion

by Steve Haberstroh, Partner

If your income was lower this year due to COVID-19 (or any other reason), this may be a unique opportunity to take advantage of a Roth Conversion.

Implementing a Roth Conversion involves taking pre-tax dollars from your Rollover IRA and contributing them into a Roth IRA. You will pay ordinary income taxes on the funds you pull from your Rollover IRA but once the funds are contributed into the Roth IRA, you will never pay taxes on those dollars or any of the investment gains ever again.*

This can be a powerful strategy, especially for younger folks. Consider John, a 40 year-old, who made $100,000 less this year due to the pandemic. After zooming for some year-end planning, his advisor recommends converting $100,000 from his Rollover to his Roth.

For the purpose of this example, let’s assume John’s tax rate is 25%, he retires at 65 and earns a 7% return compounded annually. Is it worth it?

First, since John’s tax rate is 25%, his accountant recommends he sets aside an additional $25,000 for Uncle Sam at tax time—remember the $100,000 he pulls out of the Rollover is taxable now. Once he contributes to the Roth, the $100,000 investment then compounds at 7% annually, eventually growing to roughly $540,000 at age 65. A half million dollars in a tax-free bucket? Sign me up!

It’s true. Every penny John removes from the Roth in retirement is 100% tax free. If he wants to take his family on a $25,000 trip? He pulls out $25,000. Wants to buy a $50,000 car, he withdraws $50,000.

Had John just left the $100,000 in his Rollover and never did the Roth Conversion, he’d end up with the same $542,000 (assuming the same return and time period) but every penny he’d take out in retirement would be taxable as ordinary income. If he wanted to take his family on that same $25,000 trip, he’d have to pull out nearly $35,000. Want to buy a $50,000 car, he’d have to pull out almost $70,000 from his IRA.  Uncle Sam would have to take his share.

Would John rather pay 25% on $100,000 now ($25,000) or 25% on $540,000 later ($135,500)?  I know which option I’d choose. Even assuming a much lower tax rate of 10% in retirement, he would still be better off paying 25% on $100,000 now versus 10% on a much larger amount later.

So why might the Roth Conversion make more sense if you’ve been paid less this year?  In our example, John made $100,000 less this year due to losing his job?  By “paying” himself the $100,000 via the Roth Conversion, he will have “earned” the same amount this calendar year from a tax perspective.  He may end up with a similar tax bill today but a much better one at 65.

2020 has been a brutal year for most of us so it may feel especially satisfying to do some prudent tax and investment planning.  If you’d like to learn more about whether the Roth Conversion makes sense for you, let’s have a chat then zoom in your accountant.

*This assumes the IRA tax code involving Roth IRAs does not change. Always consult with your CPA or Tax Advisor regarding tax planning.