Tax Alpha from a Roth Conversion

Unlike Donald Trump. the tax brackets from the Tax Cuts and Jobs Act of 2017 (TCJA) have another four years. This was a very popular act that lowered the marginal income tax bracket for many Americans (here’s a before and after comparison. Keep in mind the IRS adjusts these numbers each year to account for inflation). Unfortunately, the marginal income tax brackets revert to what they were before starting in 2026. This temporary period of lower tax rates may be an opportunity for you to increase your after-tax return on the investments from your retirement accounts (Traditional and Roth IRA/401(k)) by contributing more to a Roth account or converting assets from Traditional to Roth.

The important difference in a Traditional and Roth account is when you pay taxes. Both are taxed at ordinary income tax rates. Traditional accounts allow you to defer taxes now and pay when you make a distribution during your retirement years. Roth accounts force you to pay taxes when you contribute to them, but then distributions are tax free.

Roth accounts make sense for people that believe they’re in a lower tax bracket now and will likely be in a higher bracket later. For example, younger, entry-level employees are usually in the lowest tax bracket of their lives (#startedfromthebottom). As they gain experience and earn promotions, they make more money and move up in marginal tax bracket. With more money, they may become accustomed to a more expensive lifestyle that carries on in retirement. Whatever their lifestyle costs, all their Roth distributions will be tax-free because they already paid taxes when they contributed to it. If they make distributions from a Traditional account, those distributions count toward their income that year and will be taxed at the marginal income tax rate then.

If this sounds like you, or you think you’ve reached the point that your current lifestyle is how you’ll be living like in retirement, then you should consider converting assets from a Traditional account to a Roth account to take advantage of the TJCA. The benefit is the difference in tax liability due today versus later. If you think you’re making more money than you need now or will ever need (annually) for the rest of your life, then it doesn’t make sense and you can stop reading. The Traditional account is for you.

Converting Traditional assets to Roth is easy. You’ll do a rollover from one account to the other. Be careful though and work closely with a CPA to do so because all the deductions or returns you received from contributing to your Traditional account will have to be returned to the IRS; this is the cost of this strategy. The taxes are due whenever you file for that year, so you may have a little while to save up for it. Many people break down the conversion into multiple years to manage the tax liability’s impact to their cash flow.

Two things in life are for sure, death and taxes. This strategy allows you to have some control over when taxes are due and the opportunity to create some tax alpha by taking advantage of the TCJA.

Compliance stuffs
Just remember, I’m not your financial advisor so the information may or may not best apply to your situation and you should get formal advice prior to doing anything. The information/data that is shared should be double checked by you and any conclusion that is driven based on past data is not to be interpreted as my advice for your future. I will do my best to only write what I think is true and right, but mistakes happen and we’re all learning together – this is meant to be a conversation. My employer has nothing to do with this blog – in fact, they’re probably upset I’m writing here instead of working.

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