5 Powerful Questions to Ask Before a Roth Conversion

A Roth conversion can be a powerful tax planning strategy leading up to and in retirement—especially if you exceed the income threshold for contributing directly to a Roth IRA. Indeed, the benefits of a Roth conversion include tax-free distributions in retirement and the elimination of required minimum distributions (RMDs).

Yet Roth conversions don’t make sense for everyone. Thus, it’s important to weigh the costs against the potential benefits, as well as alternative tax planning strategies, before moving forward.

A Roth conversion allows you to convert all or part of your existing traditional IRA funds to a Roth IRA regardless of your income level.

What Is a Roth Conversion?

The IRS allows individuals—regardless of income—to convert a traditional IRA to a Roth IRA. A Roth conversion shifts your tax liability to the present, so you avoid paying taxes on withdrawals in the future.

Here’s how it works:

  • With a Roth conversion, you pay taxes on the amount you convert at your current ordinary income tax rate.
  • After you convert your traditional IRA to a Roth, any withdrawals you make in retirement will be tax-free if you’re over age 59 ½ and satisfy the five-year rule.
  • Since Roth IRAs don’t have RMDs, you can leave your funds to grow tax-free until you need them.

A Roth conversion can be particularly valuable in years when your income is below average, and you fall into a lower tax bracket. Nevertheless, there are a variety of factors to consider before converting your traditional retirement account funds to a Roth.

5 Questions to Ask Yourself Before a Roth Conversion

Here are 5 questions to ask yourself if you’re considering a Roth conversion:

#1: Is a Roth conversion a smart tax move right now?

In general, a Roth conversion makes sense if you expect your tax rate to be higher in the future than it is today. Thus, the most important question to ask yourself before a Roth conversion is, “Will paying taxes on the funds I convert today save me money in the long run?”

Of course, tax laws can change, and it’s impossible to predict the future. That’s why many people choose to take advantage of this strategy in years when their income is below average.

For example, if both you and your spouse work full-time, earn high incomes, and file a joint tax return, you may be in the highest tax bracket most years. But perhaps your spouse loses a large client, cutting their income in half for the year and lowering your joint income enough to temporarily put you in a lower tax bracket. In this case, a full or partial Roth conversion might make sense since your tax rate is lower than normal.

Alternatively, a Roth conversion may also be a smart tax move in years when the market is down. In most cases, your account balance will also drop alongside the market, reducing the dollar amount you convert. As a result, you’ll likely pay less in taxes than you would have before the market dropped.

While the concept of a Roth conversion may be relatively straightforward, the math can be complex. Be sure to work with a financial planner or tax expert, who can advise you on the best time to implement this strategy.

#2: How will a Roth conversion affect other aspects of my financial plan?

Depending on the amount of money you convert to a Roth IRA, your taxable income can increase substantially in the year you execute the conversion. Thus, it’s important to understand how a potential increase in taxable income may impact other areas of your finances—especially if you’re already in retirement.

For example, if you receive Social Security benefits, an increase in taxable income may trigger federal income taxes on your benefits. Currently, single filers earning more than $25,000 annually and joint filers earning more than $32,000 must pay federal income taxes on a portion of their benefits. Therefore, it’s important to know if a Roth conversion will push you over these thresholds.

In addition, an increase in your taxable income can impact your health insurance premiums if you’re in retirement.

For those who retire before age 65 and need to bridge the gap until you’re eligible for Medicare, an income boost may disqualify you from receiving The Premium Tax Credit. This credit helps subsidize the premiums lower earners pay on insurance through the Marketplace.

Similarly, retirees over age 65 may be subject to IRMAA, a surcharge you must pay in addition to your Medicare Part B and D Premiums if your income is over a certain amount.

#3: Do I have adequate tax diversification?

When planning for retirement, it’s often helpful to diversify your financial resources among various account types, including traditional (pre-tax) retirement accounts, Roth (after-tax) accounts, and taxable accounts. This can help you optimize your retirement income strategy and minimize your lifetime tax bill.

As a rule of thumb, it’s usually beneficial to have roughly a third of your assets in each type of account. So, if the majority of your assets are in pre-tax retirement accounts, a partial Roth conversion can help diversify your tax exposure.

On the other hand, converting all of your funds to a Roth IRA may push you too far in the opposite direction. While this isn’t necessarily problematic, it’s a good idea to work with a financial planner to determine your optimal mix of account types.

#4: Do I plan to transfer assets to the next generation?

One of the primary benefits of a Roth conversion is the elimination of required minimum distributions (RMDs). RMDs can increase your taxable income—even in years you don’t need them—and lower your retirement account balance over time.

Suppose you plan to leave your remaining assets to your children upon your death, for example. If most of your retirement funds are in a traditional IRA, you’ll have to take RMDs every year once you reach the applicable age (currently 73), gradually reducing its balance over time.

Even if you don’t spend your distributions, you’ll pay ordinary income taxes on them, lowering the amount you can leave your children. Plus, they’ll have to take taxable RMDs from the inherited IRA.

On the other hand, Roth IRAs don’t have RMDs. If you don’t need the income in retirement, you can let your funds appreciate tax-free within a Roth IRA, then transfer a potentially larger balance to your children upon your death. Moreover, your children can take tax-free withdrawals from the account upon inheriting it in most cases.

#5: Do I have enough cash on hand to pay taxes on the Roth conversion?

Finally, don’t forget you must pay ordinary income taxes on the amount you convert to a Roth IRA in the tax year you make the conversion. Thus, you’ll need to have enough cash on hand to pay your tax bill.

While you can pay the taxes with funds from your retirement account, most experts advise against this approach. That’s because withdrawing money from a tax-advantaged account can negate many of the tax benefits of doing the Roth conversion in the first place.

Meanwhile, if you liquidate funds from investments within a taxable account, you may end up triggering capital gains taxes. This can also diminish the benefits of converting to a Roth IRA.

Ideally, you’ll have enough cash available to avoid disrupting your investment accounts. If not, you may want to start raising cash in anticipation of a future Roth conversion.

Factors to Consider Before a Roth Conversion

Satori Wealth Management Can Help You Determine if a Roth Conversion Is Right for You

A Roth conversion can be a valuable tax and estate planning strategy. Yet due to its complexities, it may not right for everyone. Be sure to consult an experienced financial planner or tax expert to determine if this strategy makes sense for you.

Satori Wealth Management specializes in the financial planning needs of those nearing and in retirement. We can help you develop a retirement plan that considers your personal tax situation and helps you achieve your financial goals. Please schedule your complimentary RetireNow Checkup™ to see if we may be a good fit.  

5 Effective Tax Planning Strategies to Maximize Your Retirement Years

For many people, the transition into retirement is full of possibility and excitement. Yet it can also be a time of apprehension and doubt—especially when it comes to achieving financial goals. In this article, we’re sharing five key tax planning strategies that can help maximize your retirement years.

No matter how well you prepare financially for retirement, there will always be challenges that threaten to set you off course. For example, many retirees are surprised by how dramatically their tax situation changes once they stop working.

In fact, about two-thirds of retirees say if they had to advise their younger selves on a financial matter, it would be to better understand how taxes affect their retirement savings, according to a recent Thrivent survey.

Fortunately, with the right tax planning strategies, you can minimize the impact of taxes on your nest egg, so you feel more confident about reaching your retirement goals.

Tax Planning Strategies

If you’re nearing retirement, consider the following tax planning strategies:

#1: Diversify Your Savings and Investment Account Types

Generally, there are three types of investment accounts in which you can grow your retirement savings:

  • Traditional (pre-tax) retirement accounts. You contribute funds before taxes, then pay ordinary income taxes on your withdrawals in retirement.
  • Roth (after-tax) retirement accounts. You contribute after-tax dollars, then withdraw funds tax-free in retirement.
  • Taxable investment accounts. You contribute after-tax dollars and pay taxes on capital gains when you liquidate your investments.

Naturally, each type of account has its advantages and disadvantages when it comes to various tax planning strategies. Thus, you may find that diversifying your investment funds across each type of account helps you develop a more tax-efficient retirement income strategy.

Plus, in higher-income retirement years when you’re in a high tax bracket, withdrawing funds from a Roth account helps you avoid paying additional income taxes. Meanwhile, you can draw on your traditional retirement or taxable accounts in lower-income years when you’re in a lower tax bracket.

#2: Consider a Roth Contribution or Conversion in Lower Income Years

In 2023, individual taxpayers with modified adjusted gross income (MAGI) above $153,000 (or $228,000 for married couples filing jointly) can’t contribute directly to a Roth IRA. However, if your income is variable, you may want to take advantage of lower income years by contributing to a Roth or considering a Roth conversion.

The IRS allows anyone, regardless of income level, to convert all or part of your traditional IRA funds to a Roth IRA. As a result, you pay taxes on any funds you convert in the tax year you make the conversion.

Any withdrawals you make in retirement are then tax-free, and you don’t have required minimum distributions (RMDs) like you would with a traditional IRA. Thus, when it comes to tax planning strategies, a Roth conversion can be valuable as you near retirement—especially if you expect to be in a higher tax bracket in your retirement years.

Keep in mind that Roth conversions can be complex and aren’t right for everyone. Be sure to consult a financial planner or tax expert before taking advantage of this strategy.

#3: Invest in Municipal Bonds

If you’re approaching retirement, it’s often a good idea to increase your liquid cash reserves so you can still cover near-term expenses if there’s a market downturn. However, depending on where you keep your cash—for example, a money market or short-term bond funds—you may end up paying taxes on any interest you accrue.

The interest on municipal bonds, on the other hand, is exempt from federal income taxes (although you may have to pay state and local taxes, depending on the bond issuer and where you live). Therefore, investing your cash in municipal bonds can help you grow your cash reserves while generating a tax-free stream of income in retirement.

A financial professional can help you determine if this is one of the tax planning strategies that makes sense for you.

#4: Relocate to a Tax-Friendly Area

Many retirees choose to relocate or split their time between two places to reduce or eliminate their state income tax bill. For example, Alaska, Florida, Nevada, South Dakota, Tennessee, Texas, Washington, and Wyoming have no state income tax.

In addition, different states also provide different incentives and assistance programs for retirees, such as property tax exemptions, senior Citizens’ Credit Programs, or Elder Care services. Meanwhile, countries like Costa Rica and Portugal are tax-friendly retirement destinations and also boast lower costs of living. 

If you retire in a state that has a high state income tax rate, establishing a residence in a tax-friendly location or relocating altogether may be one of the tax planning strategies you want to consider. In most cases, you’ll need to spend at least 183 days of the year in your alternate home for the IRS to consider it your permanent residence.

#5: Consider Two Additional Tax Planning Strategies: Catch-Up Contributions and/or a Spousal IRA

Lastly, for some couples, catch-up contributions and a spousal IRA can be effective tax planning strategies as you near retirement.

If you’re age 50 or above, you can make catch-up contributions to your employer-sponsored retirement plan and IRA(s). In 2023, you can contribute an additional $7,500 to a 401(k) or 403(b) plan. Meanwhile, you can contribute an additional $1,000 to a traditional or Roth IRA.

Separately, the IRS requires individuals to have earned income to contribute to an individual retirement account (IRA). An exception to this provision is a spousal IRA, which allows a working spouse to contribute to an IRA in the name of the non-working spouse.

A spousal IRA can be beneficial in that it essentially allows you to double your IRA contributions each calendar year. At the same time, you can deduct these contributions from your taxes in the year you make them, lowering your overall tax bill.

Keep in mind there are certain limitations and income requirements to qualify for a spousal IRA. Be sure to consult the IRS’s website or a financial professional to see if a spousal IRA is one of the tax planning strategies that makes sense for your retirement plan. 

Satori Wealth Management Can Help You Take Advantage of These Tax Planning Strategies as You Near Retirement

The average retirement lasts 18 years, according to data from the U.S. Census Bureau. Unfortunately, excessive taxes can quickly eat away at your retirement savings if you don’t prepare accordingly.

Indeed, these are just a few examples of tax planning strategies that can help you minimize your tax bill in retirement. An experienced financial professional can help you develop a comprehensive plan that helps you leverage various tax planning strategies and preserve your nest egg long-term.

Satori Wealth Management has been leading clients through the retirement planning maze for 20 years. If you are approaching retirement and would like to speak with us about securing your financial future, we invite you to schedule your free RetireNow™ Checkup today.

Is It Better To Pay Off My Mortgage Or Invest At Retirement?

When preparing to retire, one question that is on most people’s minds is, “Is it better to pay off my mortgage or invest at retirement?” A common financial goal for many people is to retire debt-free, but most people approaching retirement are still paying off their mortgage.

Before you do anything, it’s important to evaluate your financial situation, available options, and opportunity costs.

Paying off a mortgage early can provide invaluable peace of mind and improve your cash flow. However, you might get a better return on your money by investing in the stock market, your business, or real estate while enjoying tax benefits from your mortgage.

So what’s best? Let’s examine the costs and benefits of paying off your mortgage versus investing at retirement.

Does Paying Off My Mortgage Early Make Sense?

One of the most important factors is to understand where you get the best return on your money. You will want to compare different rates of return and the risks associated with each investment option.

It is also critical to understand the impact of taxes.

Taxes are at the core of every financial decision and need to be accounted for in your analysis.

Pay off mortgage or invest

Getting the Best Return on Your Savings

In the early years of a mortgage, payments are comprised primarily of interest with a little principal. Towards the end of the loan, the opposite is true. Your payments are mostly principal with a little bit of interest.

The reason for this is that towards the end of the loan, the mortgage balance is lower, so a smaller amount of interest is being charged to the mortgage balance.

Thus, any extra principal reduction in the early life of the loan will greatly reduce the overall interest cost, saving money. The higher the interest rate, the more you will save on the life of the loan.

However, for the better part of the last decade, a 30-year mortgage has been in the 3% range. Much lower than the high-interest rates in the 5-6% range we saw just 15 years ago.

The opposite is true when investing in a diversified portfolio over time. The benefit of compounded interest and growth is significant towards the latter years of the investment. Since 1926 the S & P 500 index has averaged a double-digit return.

Your retirement plan should account for other long-term growth options that can outpace the interest savings of paying off your mortgage early. One example could be to invest in rental property instead of paying off your primary mortgage.

If you’re a business owner, consider what you could achieve by expanding or enhancing your operations. Reinvesting in your business could achieve a much greater return than saving interest on your mortgage.

As you can see, it’s important to think about where your money works best for you. And that’s different for everyone.

The Math: Pay off My Mortgage or Invest

When looking at the numbers, the difference between paying off your mortgage or investing those funds in your investment portfolio can be startling. If you decided to pay off your mortgage rather than invest, you would have paid a high opportunity cost for the feeling of being debt-free.

Historically over longer periods of time (10+ years), you’ll rarely find a time when market interest rates are better than average annual returns from a diversified investment portfolio. 

The table below compares the total interest paid on a 30-year loan to an investment portfolio growing for 30 years. We use a balance of $500,000 in our example. The mortgage rate is 3%, while the growth rate of the investment portfolio is 6%. 

Pay off Mortgage or Invest

The first thing that jumps out is the total comparison of total interest paid on the mortgage vs. total interest earned after 30 years. The total amount of interest paid over the life of the loan is $258,887 while the total return from the investment portfolio is $2,371,746! That is a massive difference in total return.

Of course, the portfolio return is twice that of the mortgage, but these are real numbers based on recent economic and market conditions over the last 10 years. The primary reason for the disparity in the totals is compounding.

Over time, your mortgage balance gets reduced, resulting in you paying less interest. You will notice that interest paid steadily declines every year in the “Interest” column.

However, the payment stays the same. So that means that more of your payment is going to the principal in the later years of the loan as you can see in the “Principal” column.

Also, note the first column titled “Pmt No.” This refers to the monthly payment being made out of 360 total payments (30 years x 12 mos). When you are halfway through the loan at payment number 180, you have paid nearly 71% of the total interest over the entire loan.

This is another reason why it doesn’t make a lot of sense to pay off a mortgage towards the end. You aren’t saving yourself much interest. It can be more beneficial to just continue making payments.

The Benefits of Paying off Your Mortgage at Retirement

It feels good not to owe money, psychologically and emotionally. Many baby boomers share the goal of paying off their mortgage by retirement. Realistically, this doesn’t happen since people move frequently and refinance in their working years.

A Paid Off Mortgage Provides Peace of Mind

Removing what for many people is their largest expense can feel liberating. Your psychological well-being can improve by removing a debt overhang and owning your own home. You will have lower cash needs on a monthly basis, allowing you to spend or invest those dollars elsewhere.

Home equity is also a good source of low-cost debt to tap in order to pay off high-interest debt, like credit cards. It can also be used to help out children, grandchildren or free up capital for all sorts of other reasons.

Another benefit is that lower monthly expenses require a smaller emergency fund. It’s a rule of thumb to have 3-9 months of your monthly expenses in an emergency fund.

Lastly, you remove the financial risk an unexpected life event could pose by impairing your ability to make payments.

No Mortgage Payment Means Lower Retirement Account Withdrawals

You can reduce your withdrawal rate from your retirement savings in the absence of your mortgage payment. This can reduce your tax liability if most of your withdrawals are coming from IRAs and 401k’s. Distributions from these accounts are income taxable.

Since you would use your non-retirement accounts to pay off a mortgage, lower withdrawals can preserve your retirement accounts more. Your average annual return can be higher in the long run by keeping those funds invested over time.

Conversely, you could keep the same withdrawal rate and afford a higher quality of living. If your retirement budget is higher than your pre-retirement budget, that means you will need the extra cash from retirement accounts. A paid-off mortgage will again keep withdrawals more manageable.

Drawbacks of Paying off Your Mortgage at Retirement

As we explained above, the opportunity cost of mortgage interest saved versus interest earned can be quite shocking. We recently discussed this in a recent post titled, “How to Retire Early at 55.”

Paying off Your Mortgage Ties Up Your Money

A mortgage from your bank is a financial partnership. They provide you with capital and you pay interest in return. As long as you keep making mortgage payments, you are the owner of the property and receive all of the appreciation of the home.

So let’s say you decide to fire your banking partner because you don’t want to pay the interest or have a payment. The trade-off is that now the equity of the property is tied up. For you to access your equity, you need to take out a home equity line of credit (HELOC) at an unknown interest rate in the future.

With lower interest rates over the last 10 years, it makes sense to use the interest rates to your advantage and obtain a mortgage. As long as there isn’t a pre-payment penalty, you can always pay it off or refinance it in the future when you have extra money.

Home equity is also a good source of low-cost debt to tap in order to pay off high-interest debt, like credit cards.

Paying off Your Mortgage Can Result in Lost Tax Benefits

When you file your taxes every year, you choose to take a standard deduction or itemize your deductions – whichever amount is greater. The standard deduction for taxpayers that are Married Filing Jointly is $24,000 ($12,000 for single taxpayers) in 2021.

Every year, you add up your itemized deductions with the hope that they are higher than your standard deduction. Expenses that qualify as itemized deductions are broken down into the following categories:

  • Medical and Dental Expenses

    To the extent that they exceed 7.5% of your Adjusted Gross Income (AGI)

  • Taxes You Paid

    Includes State and Local Income Taxes (SALT)

  • Interest You Paid

    Interest/Points you paid on your mortgage and/or vacation home

  • Gifts to Charity

    Charitable gifts made in the current year including carryover disallowed gifts made in previous years

  • Casualty and Theft Losses

    Generally, you may deduct losses caused by a federally declared disaster or by theft

  • Other Itemized Deductions

    You can only claim certain unreimbursed employee expenses if you fall into a qualified category of employment

Since mortgage interest is tax-deductible, losing the interest rate deduction by paying off your mortgage can increase your tax liability. If you purchased a home prior to 2017 and itemize your deductions, interest is deductible on the first $1,000,000 of your mortgage. The Tax Cut and Jobs Act (TCJA) of 2017 reduced this amount to $750,000.

The Act also doubled the standard deduction and reduced the State and Local Taxes (SALT) deduction by imposing a $10,000 limit. This has had a negative impact on residents of states with higher income and property taxes like California and New York.

Let’s take a closer look at Schedule A below to explain how losing your mortgage interest deduction can increase your tax liability.

Schedule A Itemized Deductions and SALT

In our example, although the state income taxes are $46,500 and the real estate taxes are $20,000, the total allowable deductible amount is limited to $10,000. The limitation causes this high-income household to miss out on $56,508 of deductions!

Additionally, you can see the total deductible mortgage interest in the amount of $26,532. The mortgage balance in our example is $1.5 million. That means that this taxpayer actually paid about $53,000 in mortgage interest for the year.

Prior to the TCJA legislation that limited the SALT deduction, there was no limitation. So using our example, prior to 2017, the total itemized deductions would have been $93,040, not $36,532. There is currently a proposal in the Build Back Better legislation to increase the SALT cap.

The bill has passed the House but faces a tougher battle in the Senate. How do you use this information to your benefit? You may have itemized deductions like medical expenses or charitable giving that put you close to the standard deduction amount. 

Mortgage interest could increase your itemized deductions to the point they are now greater than the standard deduction. So it’s an important consideration, especially if the SALT limitation is increased or goes away completely.

Final Thoughts

Like any big financial decision, it is important to weigh the costs and benefits. Financial decisions like this are complex and require a good understanding of all the variables involved.

Use a nuanced approach, giving weight to what matters most to you. Can’t decide whether you want a mortgage or not? A balanced approach is another option. You could pay off part of your mortgage and invest the remainder in whatever split you’re most comfortable with.

Maybe you decide to finance only an amount that would allow all the interest to be deductible for you.

Every decision involves risks that must be measured and managed for any particular path you choose. If you aren’t confident in making these decisions on your own, consult a fee-only financial planner to ensure you don’t leave anything out.