Military Finances 301: Is Now the Time for Roth Conversions?Retirement Funding Taxes
One upside of a down market is the ability to do a Roth conversion on sale. Here is the concept. You've decided that it is in your best interest to do Roth conversions ("withdrawing' money from a Traditional IRA and depositing the funds in a Roth IRA). On the first of the year your Traditional IRA has a balance of $100,000 and you determine that the right amount for you to convert is $20,000. If you convert at the beginning of the year, you'll convert 20% of your Traditional IRA balance. But let's say instead you delay the actual conversion until later in the year. Let's also assume that the value of your Traditional IRA declines to $80,000 (not too hard to imagine this year). If you convert the $20,000 after the decline, you'll convert 25% of the balance and more of your future growth will be tax free (theoretically).
That's the idea. But does that mean you should do Roth conversions now?
Factors to Consider Before a doing a Roth Conversion
Just because you can do something doesn't mean you should. You'll want to make sure the Roth conversion makes sense.
Let's start with tax rates. If your tax rate will be the same when you're retired, retired then converting now (and paying the taxes due with IRA funds) or leaving the funds in the Traditional IRA will put the same amount of money in your pocket in retirement. If your tax rate will be lower in retirement, the conversion may not be in your best interest. If your tax rate will be higher in retirement, then the Roth conversion becomes more compelling.
But that isn't the end of the tax discussion. If you're going to retire to a state without an income tax and you currently live in a state that has an income tax, then the likelihood that your combined tax rate in retirement will be lower than it is now is low. Think about it. If you live in VA, you will pay 5.75% on the converted amount. If your Federal marginal tax rate is 24%, it would need to increase by almost 25% (5.75/24), for it to exceed what you'll pay on the conversion. If the converse applies (you don't have a state income tax now and you will in retirement), then the Roth conversion starts to look pretty good. If you're still on Active Duty, this scenario could easily apply to you.
You'll also want to look at other "taxes". The biggest one is what's called IRMAA (Income Related Monthly Adjusted Amount). This is the amount your Medicare premiums increase due to your income (Adjusted Gross Income (AGI) to be precise). Since money taken out of your Roth IRA isn't included in AGI it won't affect whether you pay IRMMA. IRMAA isn't something to scoff. It starts at about $170 per month (per person on Medicare) and tops out at $578 per month. IRMAA kicks in at $91,000 for single taxpayers and $182,000 for those who filed jointly. This is one place in the tax code where one more dollar of income can cost you more than $1 in "taxes". Hit $91,001 or $182,001 in AGI and your Medicare premium goes up $2,041 per person for the year. If you have a lot of money in pre-tax retirement accounts, you could hit the IRMAA threshold pretty easily when Required Minimum Distributions start...especially when combined with a military retirement and Social Security.
Roth conversions can also help reduce the amount of Social Security that is subject to income tax. For military retirees, this probably isn't a concern.
Other Things to Consider
A dollar in a Roth IRA is likely more valuable than a dollar anywhere else. So, if you can, pay the taxes on the conversion with non-IRA funds. This is an excellent use for cash you have sitting on the sidelines.
If you have basis in your IRA, consider transferring the pre-tax dollars to an employer sponsored plan (401(k), 403(b), TSP) and convert the basis only. That way there won't be any taxes and all future growth on those after-tax dollars will be tax-free.
If you're not sure which direction the market is heading (and even if you think you do know where it is heading in the short-term, you probably don't), you can do the equivalent of dollar cost averaging and convert a portion of your target every month. You'll mitigate some of the risk that the market continues to decline.
Military Finances are Different
From choosing the state where you reside to having tax-free income (on active duty and potentially in retirement), military finances are different. That's why we think you should work with a financial advisor or planner who deals with current and retired military officers and NCOs each and every day. If you'd like to see how we do things, schedule a free initial consultation using the button below.
If you found this article useful, you might like the following blog posts:
Military Finances 101: Should I Use My Roth IRA as an Emergency Fund?
Retired Military Finances 401: The Widow(er)'s Penalty
Military Tax Benefit: Rollover of SGLI Proceeds to a Roth IRA