The Basics of Roth Conversions
1. In General, young, lower income (e.g., new First Officer) expect a higher tax bracket in retirement...Roth can be a no-brainer.
a. But there are other very important considerations that may go against this rule of thumb.
2. Important to know – Everyone, regardless of income, can contribute to an after-tax or nondeductible IRA.
3. What are my options if I only have pre-tax IRAs?
a. Convert the pre-tax IRA to a Roth IRA, and you will be taxed at your marginal income tax rate. Or...
b. Roll the pre-tax IRA into your 401k, then execute back door Roth the following calendar year.
4. What are my options if I have after-tax IRA contributions? Also known as “basis” in your IRA.
a. Convert to Roth and pay fewer taxes than you would if all the IRA were pre-tax.
b. But you must know your basis. Sometimes, that can be a challenge to figure out.
5. Roth Conversions are more advantageous when markets are down.
a. You will pay less taxes on the conversion.
Vanguard’s Article - “A BETR approach to Roth conversions”
Click here for the full article. (see below for hyperlink address)
6. Three situations in which the BETR (break-even tax rate) is lower than the current marginal tax rate: In other words, making a Roth conversion when your future tax rate will be lower than your current tax rate.
a. When a conversion tax is paid from a different account.
b. When the traditional IRA includes non-taxable basis.
c. When the conversion of the traditional IRA opens the “back door” to future Roth contributions.
7. Future tax rates are only one consideration for Roth conversions. What are other valuable considerations?
a. Flexibility in retirement; example, large purchases-house purchase, build.
b. Estate planning – pass on Roth to your children – 10-year required minimum distribution RMD (Required Minimum Distributions) requirements.
c. Tax diversification in retirement. “Most investors will benefit from tax diversification by holding taxable, tax-deferred, and Roth accounts” ... (also HSA (Health Savings Account))
Bonus!
8. What is the Mega-Back Door Roth?
a. Some employer 401ks allow for after-tax 401k contributions. If so, you can contribute above the normal 401k contribution limits and then convert those contributions to Roth 401k.
9. What is the next best option if I cannot save in Roth 401k or do Roth conversions?
a. Health Savings Account (HSA) - The only account that is completely tax-free.
b. Taxable Brokerage Account. I.e. a non-IRA investment account.
WARNING: Tracking Roth IRA conversions on your tax return is not easy. Many tax professionals struggle in this area. If you do not document after-tax IRA contributions and Roth conversions correctly on Form 8606 in your tax return, you will highly likely get a letter from the IRS saying you owe some taxes. Even though this situation can be rectified with proper documentation, it is never fun to get a letter from the IRS!