Thinking about doing a Roth Conversion? Beware: many people compare the wrong tax rates… a mistake that can lead to the wrong decision in retirement.
Join David McKnight to learn which of the two numbers you should be comparing instead and when paying the IRS today makes sense, and when it doesn’t.
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In this episode, David McKnight explains why a lot of people get the math wrong when deciding on a Roth conversion (hint: they compare the wrong tax rates).
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The common approach is to compare your tax bracket today with the bracket you expect in retirement, but David says that comparison can lead you to the wrong decision.
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David shares an example of a married couple filing jointly and who are considering a $200,000 Roth conversion.
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Before converting, their job, interest, dividends,and rental income already fill their standard deduction.
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Moreover, people also make the opposite mistake on the retirement side, using their highest marginal bracket as the rate on all their IRA withdrawals.
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In retirement, IRA distributions can be absorbed by deductions first, then flow through the 10%, 12% and 22% brackets – so they aren’t all taxed at 24%, even if 24% is your top bracket.
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The right comparison to make is your incremental effective tax rate on the conversion vs. your effective tax rate in retirement.
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If you’ll have a pension, taxable Social Security, interest and dividends, or rental income filling the lower brackets in retirement, compare your incremental effective rate while working with your incremental effective rate in retirement.
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Remember: not converting has unintended consequences.
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Your IRA keeps compounding until RMDs force income onto your tax return, stacked on top of Social Security and pension income.
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And those RMDs can make more of your Social Security taxable and increase your IRMAA surcharge.
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When one spouse dies, the survivor keeps most of the same IRA and income but files as a single taxpayer with much narrower brackets, which is the widow’s penalty.
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If your children inherit a traditional IRA, they must liquidate it within 10 years, likely during their peak earning years, with fewer deductions and tax rates that David expects to be higher.
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David suggests not to ask what your bracket is today vs. in retirement, but what it would cost you to buy out the IRS today vs. what it will cost to pay the IRS during retirement.
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Sometimes, that analysis says “don’t convert!”. If you’d pay 32% or 35% now and expect substantially lower rates later, paying the tax today may not make sense.
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Other times, however, paying 22% or 24% today can help you avoid a much larger lifetime tax bill over a full 30-year retirement.
Mentioned in this episode:
David’s newest USA Today bestselling book: The Secret Order of Millionaires: Seven Principles for Building Tax-Free Wealth
