Pay Me Now or Pay Me Later

As we live in a free country, sometimes, Uncle Sam gives us a choice.  When it comes to the taxation of retirement accounts, he takes the stance – “Pay Me Now or Pay Me Later”.  Back in 1972, Fram Oil Filters used this slogan in a commercial.  They claimed someone could pay the premium price for a Fram Oil Filter now, or, pay a mechanic later to fix all the problems caused by using a different oil filter.  They eluded that you were going to pay the price either way.  (reference the old Fram Oil Filter commercial from 1972 – https://www.youtube.com/watch?v=OHug0AIhVoQ )  Similarly, when it comes to contributing to a retirement account, you get to choose; pay income taxes now or pay income taxes later.  Either way, Uncle Sam is going to get his cut!

When contributing to a retirement account, there are typically two main choices, Pre-tax and Roth.  Pre-tax allows you to defer paying income tax on your contribution amounts until taking a distribution in the future.  However, both the amount you contribute and any growth are fully taxed when distributed.  Some examples of these are a traditional IRA or a typical 401(k).  A Roth option allows you to put in funds from your income that has already been taxed.  Since you have already paid income tax, both your contribution and any growth can be distributed tax-free.  An example of these accounts is a Roth IRA or a 401(k) with a Roth election.  You can either pay taxes when you are putting into your retirement account, or you can wait and pay when you take money out – the choice is yours.

However, there is also another option called a Roth Conversion.  This is a process where you are allowed to move money from a pre-tax retirement account into a Roth account.  At first glance, this sounds like a no brainer!  Who doesn’t want money to grow tax-free, right?  Well, like most things, this is only a piece of the puzzle.  When it comes to financial products, services, and strategies – you must understand all of the consequences, both good and bad, in order to determine what is best for you and your situation.

To start, executing a Roth Conversion triggers a taxable event.  The amount being converted counts as taxable income and Federal/State income taxes would have to be paid.  But wait, there’s more!  For example, it is important for someone who is already drawing Social Security to determine any potential changes in their benefit’s taxation.  Up to 85% of Social Security is taxable.  If someone isn’t already at the max level, taking a distribution to complete a Roth Conversion may increase the tax on their Social Security.  The increase in taxable income may also trigger an increase in Medicare Premiums, affectionately known as IRMAA (Income-Related Monthly Adjustment Amount).  It is also important to know that you are not allowed to convert RMDs (Required Minimum Distributions).  If someone is already of RMD age, they would have to convert an amount in addition to their RMD.  Like all decisions we make, it is important to consider all of the consequences and how they impact our entire situation.

Having run a multitude of analyses for clients over the years, I can say everyone’s situation is different.  For some, completing a Roth conversion statistically places them in a better financial situation.  Even with all of the potential tax consequences, mathematically, they expect to end up paying less taxes and keeping more money for themselves.  Many of these variables are not guaranteed, but completing statical analysis can help someone determine their own probability of success.

Roth conversions may also be important to some when considering the impact on their heirs.  A Roth grows tax-free and this does not change when passing on to a beneficiary.  If someone’s goal is to minimize the tax impact for their beneficiaries, a Roth conversion may be a way of accomplishing this goal.  However, many things have to be considered such as the expected tax situation of each beneficiary compared to the account owner.

As always, everyone’s situation is unique and sometimes there is not a clear right/wrong answer.

There is no age limit for completing a Roth Conversion.  You can complete one at a young age while still working or even if you are fully retired.  However, since income is based on the calendar year, Roth conversions do not follow the tax deadlines like contributions.  If you are considering a Roth conversion strategy, you’ll need to act fast since the end of the year is near and it takes time to make the appropriate money moves.  If you’d like our help analyzing your personal financial situation to determine if a Roth conversion is right for you, don’t delay – give us a call today!

Investing involves risk including the potential loss of principal. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance does not guarantee future results. Consult your financial professional before making any investment decision. Diversification does not guarantee profit nor is it guaranteed to protect assets.

Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. Information is not an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein.

Neither the named representative nor Investment Advisor gives tax or legal advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult your tax professional for specific guidance.