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Timely IRA Conversions & The 2018 Tax Cuts


Last updated:  1/26/2018

Do you have a lot of money in your Traditional IRA?  Do you know that when you withdraw money from your Traditional IRA it will be taxed (excluding any after-tax, NON-deductible contributions)?  Yep, it will.  Same thing with your Simple IRA, SEP IRA, and also any pre-tax money you have in your work retirement plan (401k, 403b, etc).

2018 TAX REFORM UPDATE: Unless you live under a rock, you are probably aware that changes have been made to the tax code.  For many, this will result in a lower effective tax rate starting in 2018.  With these changes to the tax code now in effect, an IRA conversion might make more sense now than ever before.  I have a section below that is dedicated to the 2018 tax cuts, with ideas for how you might be able to take advantage of these tax cuts by doing an IRA conversion.  Read on to learn more.

What can you do to potentially save on taxes?  Consider doing timely IRA conversions.  With timely IRA conversions, you might save yourself a significant amount on taxes over the life of your IRA(s).

First, how are these conversions different from the conversions in the ‘Backdoor Roth IRA Strategy’?  I know, it’s a little confusing.  With an IRA conversion, you are simply moving (converting) money from your Traditional IRA into your Roth IRA.  So why is one IRA conversion taxed and not the other?  It all boils down to how the initial contributions were made to your Traditional IRA….pre-tax, deductible contributions (most common) OR after-tax, NON-deductible contributions (like with the 'Backdoor Roth IRA Strategy').  Pre-tax, deductible contributions are the most common.  With a Traditional IRA, most contributions are made on a pre-tax basis, and you get a tax deduction when you make the contribution.  When you move (convert) this type of contribution from your Traditional IRA to your Roth IRA, you will owe taxes on the amount you move (convert) into your Roth IRA.  With the ‘Backdoor Roth IRA Strategy’, it’s different.  You generally don’t owe taxes on the Backdoor Roth IRA conversion because it involves after-tax, NON-deductible contributions…and these contributions are typically only in your Traditional IRA for a very short period, as they are almost always converted into your Roth IRA shortly after the contributions are made.  So it’s highly likely that any money you have in your Traditional IRA came from pre-tax, deductible contributions.  If you rolled over an old 401k plan into your Traditional IRA (aka Rollover IRA), this money also came from pre-tax, deductible contributions.  For the purpose of this piece, I am only referring to these pre-tax, deductible contributions, which are the most common…and likely the only type of money you have in your Traditional IRA.

When do you have to pay the taxes on this type of IRA conversion?  The amount you move (convert) from your Traditional IRA into your Roth IRA will be added to your taxable income in the calendar year that you do the conversion.  So make sure you have enough money available in a non-IRA account (checking, savings, taxable brokerage account, etc) to pay the taxes on any amount you move (convert) from your Traditional IRA to your Roth IRA.

Can you have the taxes withheld from your IRA conversion?  If you are under the age of 59 ½, make sure you do NOT have the taxes withheld from your IRA conversion as any amount withheld will be considered an early distribution and subject to an additional 10% penalty tax.  If you are over the age of 59 ½, this 10% penalty tax doesn’t apply.  So in this case, you could have the taxes withheld from your IRA conversion, but I suggest paying the IRA conversion taxes with other money (checking, savings, taxable brokerage account, etc) as this would allow you to keep the maximum amount in your tax-free Roth IRA.

So why would you do an IRA conversion?  At some point, you're going to pay taxes on the money you have in your Traditional IRA.  Whether you simply withdraw money from your Traditional IRA in retirement or move (convert) these assets into your Roth IRA, you will eventually owe taxes on this money.  It's not a matter of if, but when.  Once you move (convert) the money into your Roth IRA, you will no longer owe taxes on this money...it will grow tax-free (as long as you leave it in your Roth IRA until you are 59 1/2).  Nobody knows what tax brackets might look like several years from now.  So by doing an IRA conversion, this should eliminate that unknown risk.

Do you have to move (convert) ALL the money from your Traditional IRA into your Roth IRA?  Nope.  This isn’t an all or none thing.  You can convert as much or as little as you choose...you don't have to convert your entire IRA all in one year.  You can do a "partial" IRA conversion.  Why is this important?  Because if an IRA conversion would bump you up into the next tax bracket (remember, the amount you convert is added to your taxable income), then you might consider doing a "partial" IRA conversion.  You could spread these "partial" IRA conversions out over the next several years, hopefully keeping you just below the next highest tax bracket.

Okay, so what do I mean by doing a “timely IRA conversion”?  Consider doing these conversions when the stock market, and likely your account, experiences a correction (say 5-10%).  This way, you are paying taxes on a depressed value.  And any recovery of the assets you convert will then be tax-free…because now the money is in your tax-free Roth IRA.  Now that is a “timely IRA conversion”.

Here's a hypothetical example:  Let's say you have $1,000,000 in a Traditional IRA, and your account experiences a 10% correction and pulls back to $900,000.  Because the account is at a depressed level, you decide to convert $50,000 from your Traditional IRA into your Roth IRA, and pay the taxes on this $50,000.  So now you have $850,000 in your Traditional IRA and $50,000 in your Roth IRA.  When your account recovers from its recent losses and these assets gain back what they lost, you now have approx $944,400 in your Traditional IRA and approx $55,600 in your Roth IRA totaling $1mil.  But the $55,600 that is now in your Roth IRA grew back tax-free, so you avoided taxes on the $5600 of growth in this account.  And there, you just took advantage of a stock market correction, potentially saving you on future taxes.  Do this a few times over the next few years, and you might end up with all your IRA money in your tax-free Roth IRA.

When is another good time to consider an IRA conversion?  Another good time to consider an IRA conversion is when you are having a down income year AND you think you will be in a lower tax bracket.  You are going to pay taxes on these assets someday anyway, so if you can pay at a lower rate, that’s a good thing.  Again, just make sure you have enough available cash to pay the taxes on your IRA conversion.

What is another possible benefit from doing an IRA conversion?  Remember, the ‘Backdoor Roth IRA Strategy’ doesn’t really work if you have other money in your Traditional IRA, Simple IRA, or SEP IRA.  So if you ultimately convert ALL the money you have in these accounts, this will allow you to proceed with the ‘Backdoor Roth IRA Strategy’…allowing you to get even more money in your tax-free Roth IRA.

And one more benefit from doing an IRA conversion:  With a Traditional IRA, you will be subject to Required Minimum Distributions (RMDs) when you reach age 70 1/2.  With a Roth IRA, you are not subject to RMDs.  So any money you move (convert) from your Traditional IRA to your Roth IRA, will not be subject to RMD's when you reach age 70 1/2.  And again, this should eliminate the unknown risk of what tax brackets might look like several years from now.

2018 TAX REFORM UPDATE:  Unless you live under a rock, you are probably aware that changes have been made to the tax code.  For many, this will result in a lower effective tax rate starting in 2018.  There are still seven different income tax brackets, but they've changed.  In 2017, the seven brackets were:  10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.  In 2018, the seven brackets are:  10%, 12%, 22%, 24%, 32%, 35%, and 37%.  The income ranges for each bracket have changed too.  Business Insider has a good article that includes a 2017 vs 2018 side-by-side comparison, along with some additional info.  Here's the link:  Business Insider article (Click here).  These tax cuts are NOT permanent.  They are expected to remain in place for the next 8 years (through 2025).  Then in 2026, they are scheduled to revert back to the 2017 tax brackets (with slight changes to the income ranges due to inflation adjustments), absent further legislation.  But with politics, who knows what might happen between now and then?!?  Remember, with an IRA conversion, the ultimate goal is to save on taxes.  So what can you do?  Consider taking advantage of these lower rates by doing an IRA conversion.  By doing an IRA conversion now, you are choosing to pay the taxes on your IRA based on the current tax brackets, essentially locking in these lower rates. Then, if/when tax rates go back up, it won't matter because the IRA assets you convert will then be in your tax-free Roth IRA account.  If you have money in an old 401k plan (or other work retirement plan) that is eligible for a rollover, this might be a good reason to roll these assets over into an IRA account...because then you would have the option to convert these assets into a tax-free Roth IRA too, while the tax brackets are slightly lower.  And remember, you don't have to convert your entire IRA all in one year.  You can do "partial" IRA conversions and spread these out over the next few years, hopefully keeping you just below the next highest tax bracket.  Again, these tax cuts are NOT permanent.  So consider taking advantage of these tax cuts before they are gone.  Don't let this opportunity pass you by without understanding the potential benefits.

Who would most likely benefit from doing an IRA conversion? With the tax cuts, many people could benefit from doing an IRA conversion(s). If you expect your income to remain stable or increase in future years, you would likely benefit from doing an IRA conversion now while the tax cuts are in effect. Are you retired? Are you under the age of 40? Are you so successful that you are always in the highest tax bracket and expect to remain there? If any of these describe you or your situation, then you are a great candidate for an IRA conversion(s). If you are retired, there is a good chance your taxable income stays pretty consistent. This gives you a great opportunity to take advantage of these tax cuts, likely by doing "partial" IRA conversions...gradually moving money from your Traditional IRA to your tax-free Roth IRA each year, while staying just below the next highest tax bracket.  If you are under the age of 40(ish), you are also a great candidate for an IRA conversion. By moving (converting) money from your Traditional IRA (or old 401k plan) into your tax-free Roth IRA, you have several years (likely 20+) to benefit from the tax-free growth of your Roth IRA. If you are always in the highest tax bracket and expect to remain there, you are a great candidate for an IRA conversion. The top tax rate went from 39.6% down to 37%. So if you are always in the highest tax bracket and expect to remain there, you might as well take advantage of this lower rate...because it might not be around forever.  If you fit any of the above descriptions, you could potentially save yourself some serious money on taxes by doing an IRA conversion(s) while these tax cuts are in effect.  If you know someone who fits any of the above descriptions, share this article with them (copy, paste and email the link/url).  It could be your parents, your kids, or maybe a co-worker who could take advantage of these tax cuts by doing an IRA conversion.

When does it NOT make sense to do an IRA conversion?  Even with the tax cuts, an IRA conversion is not for everyone.  If you are confident you will be in a lower tax bracket in the not-too-distant future (maybe you plan to retire in the next few years), then you should probably leave the money in your Traditional IRA until that time.  Might as well pay the taxes when you are in a lower tax bracket.  If you have large year-to-year fluctuations in your income, then you probably shouldn't do an IRA conversion in a high income year as this is when you are more likely to be in a higher tax bracket.  Might as well wait until you have a low income year, assuming a low income year would take you to a lower tax bracket.  But remember, nobody knows for sure what tax brackets might look like in the future. So if you want to take away that uncertainty, you could still consider doing an IRA conversion.

Want to run the numbers yourself? Bankrate has a very helpful calculator that allows you to do your own IRA conversion analysis.  Here is the link:  Convert IRA to Roth IRA Calculator (Click here)

What should you do?  Before you do anything, run this by your tax advisor.  If you have money in an IRA account (Traditional IRA, SEP IRA, Simple IRA, etc) or old work retirement plan (401k, etc), share this article with them (copy, paste and email the link/url).  Ask them if you might benefit from converting some or all of your IRA/401k money into a tax-free Roth IRA while the tax brackets are slightly lower.

HyLine Bottom Line:  The 2018 tax cuts are NOT permanent.  An IRA conversion is one way to take advantage of these lower rates.  By doing an IRA conversion now, you are choosing to pay the taxes on your IRA based on the current tax brackets, essentially locking in these lower rates. Then, if/when tax rates go back up, it won't matter because the IRA assets you convert will then be in your tax-free Roth IRA account.  Timely IRA conversions like this might save you a significant amount on taxes over the life of your IRA(s).  Unless you like paying taxes, that's a good thing.

What can I do at HyLine Wealth to help you take advantage of the 2018 tax cuts?  I can help you with everything in this article.  I can help you determine if/when an IRA conversion makes sense for you.  I can help you take advantage of the 2018 tax cuts by doing an IRA conversion(s).  I can help you with "partial" IRA conversions.  If you have an IRA at another firm, I can help you transfer it.  If you have an old retirement plan (401k, etc) at a previous employer, I can help you roll this over to an IRA.  Transferring an IRA or rolling over an old 401k plan is typically a pretty easy process.  I will help with all the required paperwork so you are ready to do an IRA conversion if/when it makes sense for you.  I will consult with your tax advisor when necessary to make sure they approve.  And you don't need to live in South Dakota to use my services...technology makes it very easy to work with clients remotely.  It's more important you work with an advisor who understands these issues and has a system in place to process everything efficiently.  Bottom line, I will make this all very easy for you.

Want more investment "tips"?  We have a lot more great ideas and suggestions to help you be smarter with your money.  CLICK HERE to get these "tips".

CLICK HERE to Get More "Tips"

Questions?  Don’t hesitate to reach out.  If you have questions on anything, feel free to email me at brock@hylinewealth.com or call me at (605) 275-2343.

Think some of your friends might benefit from doing an IRA conversion?  Great!  Use the social media links at the bottom of the page to share this with them.

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Brock Hyde
Investment Advisor
brock@hylinewealth.com

HyLine Wealth
5809 S Remington Place, Suite 101
Sioux Falls, SD 57108
Office (605) 275-2343

Location-Independent:  Pretty much wherever you are located, we can work together.  I am registered in the state of South Dakota and have an office in Sioux Falls.  The “de minimis exemption” allows me to do business in most other states (with only a few exceptions).  I consider myself "location-independent" as I use a heavy dose of technology to communicate and serve you.  This includes screen sharing technology, electronic signatures when possible, and shared client portals so we can view the same information at the same time.  Frankly, I can probably offer you better service than your "local" financial advisor.

HyLine Wealth is an investment adviser registered in the State of South Dakota. We do not provide tax or legal advice. Past performance is no guarantee of future results.  Always consult your financial advisor, tax advisor, attorney, and/or insurance agent before implementing any specific strategy to make sure it is right for you and your unique situation.  We are not responsible for the accuracy or upkeep of information on the links we provide to outside websites.  If/when we provide a link to an outside website, be sure to independently confirm the accuracy of any information.