In a previous blog post, I shared about the decision that Sharon and I made for her to take some time away from Cummins to stay home with our son Hudson. This decision has really changed our calculus on a lot of different things, including budgeting, cash flow, and healthcare, of which a lot of them don’t feel like much of an opportunity; however, one thing that we did turn over that creates a great opportunity is that we land in a lower tax bracket because our income is reduced. This can mean a lot of things to a lot of people, but as I put on my financial planner hat, the light bulb blinked on: Roth Conversions.
For those who may not be familiar with the term “Roth Conversion”, it’s a strategy where you take money from a tax-deferred account like an IRA or 401K: Pay taxes on your money now, and then let it grow tax-free over the life of the account. For those tax nerds out there, you can find the IRS rules in Publication 590-A.
The reason you would do this is you’re making an educated guess, often with a trusted advisor, that your tax rate today is going to be lower than your tax rate in the future when you’re retired. Many people go into retirement with 401Ks or IRAs that will necessitate large required minimum distributions late in life that can impact things like tax rates and Medicare premiums. (We just recently had an article by Warren Ward on this topic).
Having a diversity of account styles, like taxable brokerage accounts, IRAs, and Roth IRAs, will allow your retirement plan to be more flexible and enable you to be the most efficient with your taxes. We most often will see this executed from an IRA to a Roth IRA, but there are 401K plans out there that allow this to be done within the plan. Unfortunately, this is not the case for the Cummins RSP.
These opportunities generally come up when people retire “early” (or at an age when they are not able or don’t want to access their qualified accounts), and their income significantly reduces. We would work with the client to estimate their taxes and discuss how much can be reasonably taken out of the account and then pay taxes on those funds. That said, just because you’re not in the early retirement phase doesn’t mean that you can’t also take advantage of this strategy. Any time that your income has a dip is a great time to look at this strategy, as Sharon and I have found with our current change in life.
Another thing to remember with Roth conversions: you need to complete the conversion before the end of the calendar year to be counted on that year’s taxes. This varies from the Roth Contribution rules where you can contribute up to when you file your taxes, which for most is in the following calendar year. Recognizing this, you only have a few more weeks to action this strategy to ensure that the conversion is completed in the 2022 tax year.
As is the case with many opportunities, there is a season for them. Whether you are at the point of early retirement and can afford to take a tax hit now to reduce your tax bill later, or you find yourself in a position of temporarily reduced income, you can use strategies to improve your long-term financial health and flexibility.