Tax Hikes Ahead: Should You Do A Roth Conversion To Lock In Rates? (EP.172)

0:28We all need to make smart decisions with our money. type topic, and that's Roth conversions in light of the potential expiration of the Tax Cuts and Jobs Act in 2026. For many retirement savers, this presents an important opportunity to lock in today's lower tax rates. So with tax rates set to increase in 2026, when the TICJA or Tax Cuts and Job Act expires, it's crucial to think about your tax strategy now. Roth conversions let you pay taxes up front, potentially at a lower rate, shielding you from higher future taxes. But with only a couple years left to act, time is running out to take advantage of the current tax environment.

1:13So just to quickly explain Roth conversions, a Roth conversion involves transferring funds from a traditional IRA to a Roth IRA. You'll pay taxes on the converted amount, but future growth and withdrawals will be tax-free. The big question is, do you pay taxes now or later? The best candidates for Roth conversions are people who expect their tax rate to rise in retirement or those looking to avoid required minimum distributions later on. When you're doing tax planning around Roth conversions, timing and tax bracket management are key. One common strategy is to fill up a tax bracket, which just means converting enough money to reach the top of a lower tax bracket without spilling over into a higher one.

2:03And so I thought I might walk through a couple of examples that I tend to see just so you can better understand how this works. So just at that most basic level of filling up a lower tax bracket, just imagine a couple in their early 60s, semi-retired or maybe nearing retirement, earning just$60 ,000 annually. So as of right now, that would mean they're in the 12 % tax bracket, which tops out at around$89 ,000 for married couples filing jointly. Let's say they decide to convert$20 ,000 from their traditional IRA to a Roth IRA. This moves them closer to the top of their current tax bracket, allowing them to pay just at that 12 % rate on the conversion amount now, rather than potentially higher rates in the future as they're required to make minimum distributions from their IRAs, as they have social security income, etc.

2:59So in this case, the goal is to strategically convert enough over several years to minimize the lifetime tax liability. So that's sort of like the base case scenario that applies to just about anybody approaching, nearing, or in retirement. Another common situation that I see at year-end tax planning is exercising incentive stock options, or ISOs. So in this case, let's imagine a tech executive in their mid-50s, and let's say they're considering exercising a significant amount of these ISOs, of these incentive stock options. Roth conversions can be a bit more complex when you factor in equity compensation, and the executive's income is already volatile due to the large income spike when exercising those ISOs.

3:49So they must carefully balance the decision. If they convert too much into a Roth IRA, they could push themselves into a much higher tax bracket. Whereas on the other hand, spreading out the ISO exercises and Roth conversions over a few years might provide a tax-efficient strategy. A third example that I typically see are choices between accelerating or delaying charitable contributions. So let's picture a high net worth individual who's making substantial annual charitable donations. She's contemplating whether to accelerate her contributions before 2026, thereby reducing her taxable income now.

4:30And in her case, a Roth conversion in conjunction with charitable deductions could offset a portion of the taxable income triggered by the conversion. But should she accelerate donations now or wait? That's the thing about tax planning. There's no one right answer, but aligning charitable giving with a Roth conversion can help manage taxes. One final example for you to think about that I often see near year-end is reducing the size of your estate using Roth conversions. Now, with the expiration of the Tax Cuts and Jobs Act, we might see, and a lot of talk is coming forth, that the taxable estate level is going to come down.

5:16And so, for someone who is concerned about estate taxes, a Roth conversion can kind of be a sneaky opportunity. Because when you're converting to a Roth IRA, you're essentially shrinking the size of your taxable estate. And a retiree with substantial assets might consider whether paying taxes on a conversion now will lower the overall tax burden for their heirs later. Now this I see often as part of a larger estate planning strategy, but decisions around estate taxes and Roth conversions must be carefully weighed around this time of year with an advisor. Now, I've been talking a lot about federal state taxes.

5:58There are also state tax implications, and that can add another layer of complexity to Roth conversions. So with the potential sunset of the$10 ,000 cap on state and local tax deductions in 2026, that could really impact your decision. For example, if your federal tax rate increases, but you can get a higher deduction on state taxes, then it might make sense to wait on a Roth conversion. However, if you're subject to the alternative minimum tax, that deduction may disappear, making an immediate conversion more appealing. The other thing that you have to keep in mind is state residency can play a critical role, particularly if you're living in a high-tax state now, but plan to retire to a lower-tax state.

6:45So in that case, waiting until you relocate could result in significant savings on your Roth conversion. It's like I said at the beginning of the episode. Timing matters, and getting it right is essential to minimize your lifetime tax burden. And all of this, in my opinion, reinforces why it's crucial to work with a financial advisor who understands tax strategies. This isn't just a decision that people ought to make on their own. Running a detailed tax projection can help you weigh the federal and state tax considerations and determine the best course of action. And given that the Tax Cuts and Jobs Act expires in 2026, it's really important to start this conversation sooner than later.

7:33Now, there isn't a one-size-fits-all strategy. That's what's tough about doing an episode like this. Because every situation, whether it's filling up a tax bracket, managing stock options, combining charitable contributions, or even planning your estate. These things require careful thought and planning. And the important thing is to step back and look at your entire picture and act before 2026. One last thing I'm going to leave you before signing off. If you go to the longterminvestor.com, I have a flow chart that can kind of help you through should I consider doing a Roth conversion that will be in the show notes.

8:12I also wanna call out that if you schedule a call at the top of the page, there is a button that says work with me. Anyone who becomes a PlanCorp wealth management client will jump to the top of the list to be part of our tax preparation tax planning group in 2025. So if you've wanted your financial advisor and your tax returns all to be under one roof, this is really a great opportunity. And if we can get started now, we will be able to accommodate you for your 2025 tax season to file that 2024 return. As always, thanks for listening. And until next time, to long-term investing. Thanks for listening to the Long-Term Investor Podcast.

8:56To access free financial resources and submit questions to be answered on the show, visit thelongterminvestor.com. Peter Lazaroff is an employee of PlanCorp and BrightPlan. All opinions expressed by Peter and any podcast guests are solely their own opinions and do not reflect the opinions of PlanCorp or BrightPlan. This podcast is for informational purposes only and should not be relied upon as a basis for investment decisions. Clients of PlanCorp and BrightPlan may maintain positions in the securities discussed in this podcast.