On Money & More – Dec 2023/Jan 2024

Taxes are something that are always on investor’s minds. With record-high fiscal deficits and the “sunsetting” of the Trump tax cuts after 2025, a lot of people have raised concerns that their future tax rates will be going up. Last month we tackled the subject of gifting and how this can potentially reduce your tax burden. In this month’s issue, we wanted to address another financial planning strategy that may have tax benefits for you, a Roth conversion. Roth conversions are transactions in which you transfer funds from your Traditional IRA (or other tax-deferred account such as a 401k) into a Roth IRA. As a reminder, with a Traditional retirement account you defer the taxes until the funds are withdrawn. In a Roth, you pay the taxes today, but your funds grow and are withdrawn tax-free. Thus, when you do a Roth conversion, you’ll be paying tax now to potentially reduce your taxes later (there is no guarantee that taxes will go up, they could go down!).

Why would you want to pay more taxes today? Depending on your financial situation and goals, Roth conversions can be a valuable strategy for tax and retirement planning as they provide tax diversification and the potential for future tax savings. Here are some examples when a Roth conversion might be beneficial:

  1. Tax Diversification: Roth IRAs and Roth 401(k)s provide tax-free withdrawals in retirement. Converting a traditional retirement account (such as a traditional IRA or 401(k) plan) to a Roth IRA can diversify your retirement income sources, helping you manage your tax liability more effectively.
  2. Future Tax Rate Expectations: If you anticipate being in a higher tax bracket in retirement, converting to a Roth can make sense. Paying taxes on the conversion at your current tax rate may be preferable to paying higher taxes on future withdrawals. While a change in Federal tax laws might lead to higher anticipated rates, other things to consider are Required Minimum Distributions (RMDs) or pension income as well.
  3. Early Retirement Planning: Unlike Traditional IRAs, Roth IRAs allow you to withdraw contributions penalty-free at any age. If you plan to retire early, a Roth conversion can provide a tax-advantaged source of income. Conversely, they don’t have required minimum distributions, allowing you to allow your money to grow tax free longer than a traditional IRA would allow.
  4. Estate Planning: Roth IRAs can be a useful tool for estate planning. Converting to a Roth allows you to pay the taxes upfront, reducing your estate’s overall tax liability and making it easier to pass on to heirs tax-free.
  5. Take Advantage of Low-Income Years: If you have a year with lower income, perhaps due to retirement or taking a sabbatical, you can strategically convert traditional retirement assets to a Roth while still in a lower tax bracket.

Whether or not a Roth conversion makes sense will depend on your individual circumstances. Be aware that there are rules and limitations associated with a Roth conversion. And while this might be a powerful tool to mitigate your lifetime tax burden, be sure to talk with an Advisor about whether this might be the right strategy for you.

All opinions and data included in this commentary are as of November 13, 2023 and are subject to change without notice. The opinions and views expressed herein are of Cutler Investment Counsel, LLC and are not intended to be a forecast of future events, a guarantee of future results or individual investment advice including the asset allocation provided. Nothing herein should be construed as tax advice. This article is provided for informational purposes only and should not be considered a recommendation or solicitation to purchase or sell securities. This information should not be used as the sole basis to make any investment decision. The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed. Investing involves risk, including the potential loss of principle. Neither Cutler Investment Counsel, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.