“What’s a bracket conversion, and why might I need a strategy for one?”
Good questions. Let’s begin with a few suppositions:Let’s suppose, in saving for retirement, you have contributed to a Traditional IRA. And you know the day is fast approaching when Uncle Sam will want the tax that’s owed on that money. That day might be when you’re forced to take your Required Minimum Distribution (RMD) at age 70.5, or when you voluntarily take a distribution from your IRA. Bottom line here: You have an IRA full of tax-deferred dollars and those taxes will one day be paid. That much is for sure. But to some degree, how much tax is paid on those dollars and from whom could be up to you…
“Render unto Caesar the things that are Caesar’s…”
If you die with “X” amount of money in a tax-deferred IRA, and you’ve left that money to a beneficiary, then that inherited money will be taxed at your beneficiary’s tax rate – not yours. (An inherited IRA comes with the responsibility to begin “making good” on any taxes owed – and do note that there are different rules applicable to IRAs inherited by spouses and for those inherited by non spouses. That is a discussion for another post. The common denominator, however, is that taxes could play a significant role in this equation. See what I did there with “denominator” and “equation”?) And if you believe your beneficiary will be in a higher tax bracket than you’re currently in, even more taxes will be feeding Caesar’s furnace. So, if you have a Traditional IRA, you may be able to take advantage of a bracket conversion. In a bracket conversion, you convert a portion of your IRA – an amount that won’t push your taxable income into the next bracket – into a Roth account. That portion will be treated as ordinary income and you will have to pay the tax on it. (Caesar’s happy.) However, once it’s in the Roth, it grows tax free and will one day be inherited by your beneficiary. (Beneficiary’s happy.) And you, at your presumably lower tax rate, will have “rendered” the amount owed, and you now have a Roth growing tax free that will one day be inherited by your heirs. (And now all of you can be happy.)
Again, an assumption is being made that the tax bracket you’re in at the time of the conversion will be lower than that of your beneficiary at the time when the account is passed on. If taxes are likely higher for you now than they will be for said beneficiary, then Caesar may just have to wait. (Unless you can tell me when you’re going to die, assumptions will have to be made in such matters.)
The advantage to your heirs isn’t the only benefit, mind you. Having money in both tax-deferred and after-tax accounts provides a bit of flexibility in your tax planning. No one knows for sure what the tax rate or tax bracket structure will look like in years to come, and having money in both types of accounts allows you to hedge your bets, so to speak. Your tax preparer should be able to help you determine the amount to convert and still remain in your current tax bracket. Make no mistake about it, you will be paying the tax on the conversion, and you’ll need to account for that in your cash flows. Of course, you don’t have to convert it all at once. You can do it – now and later.
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If it makes sense tax-wise, and cash-flow wise, then it certainly should be considered. Speak with your tax preparer and financial planner to see if a bracket conversion make sense for you.