Window of Opportunity, Part 2: Looking Beyond the Roth Conversion
A Roth conversion can be an appealing retirement tax-planning strategy: recognize taxable income now, potentially at a favorable rate, in exchange for tax-free qualified withdrawals from the Roth account later.
But there’s an important catch.
A Roth conversion doesn’t affect only your income tax bracket.
Because the amount converted generally increases your taxable income in the year of the conversion, it can interact with other parts of your financial life. And reducing taxable distributions in future years can have effects that extend well beyond the retirement account itself.
That’s why Roth conversion planning requires looking at the entire tax picture.
Today’s conversion can affect more than today’s tax bill
Suppose you retire and find yourself with significantly less taxable income than you had while working. You may have room to recognize additional income without moving into a tax bracket you consider unfavorable.
That can make a Roth conversion attractive.
However, deciding how much of that available bracket to “fill” requires careful analysis. Additional income can affect deductions and credits, and depending on your age and circumstances, it may also have implications for other income-based costs.
Medicare is an important example. Higher income can result in income-related adjustments to Medicare premiums, and the income used to determine those adjustments generally comes from an earlier tax year. A conversion therefore needs to be evaluated not only for the income tax it creates, but also for potential ripple effects.
Think several years ahead
The other idea of the equation is what happens after the retirement planning window closes.
Eventually, Social Security benefits may begin. RMDs can add another source of taxable income. Investment income, pensions and other resources may be part of the picture as well.
Those income streams can interact and can all be counted as taxable income.
For example, depending on a retiree’s overall income, a portion of Social Security benefits may be taxable. RMDs can increase taxable income regardless of whether the retiree actually needs the distribution for living expenses. Higher income can also affect Medicare premiums.
Reducing the balance of a traditional retirement account through strategic Roth conversions during earlier, lower-income years may therefore have consequences beyond the tax paid on the conversion itself.
In other words, the potential value of a Roth conversion isn’t always visible on this year’s tax return.
Tax planning versus tax preparation
This distinction highlights the difference between preparing a tax return and engaging in forward-looking tax planning.
A tax return tells us what happened. Retirement tax planning asks what could happen under several different scenarios.
What if you convert a certain amount this year? What happens if you convert more, or less? How might today’s decision affect RMDs, taxable Social Security income or Medicare costs later? And how do those outcomes change when we look at several years together rather than one year in isolation?
The objective isn’t necessarily to pay the least possible tax this year. In some cases, deliberately paying somewhat more tax during a favorable planning window could contribute to a better long-term result.
That’s precisely why the answer is different for every taxpayer.
A Roth conversion should be evaluated as one piece of a larger retirement tax strategy. If you’re approaching or already in this retirement planning window, our team can help model the potential tax consequences today and in the years ahead.
