Tax Diversification and the ROTH Conversion Debate!

If the downturn of 2000-2002 didn’t teach us about portfolio diversification, 2008-2009 certainly did. Simply put, diversification spreads risk. Most people understand the importance of portfolio diversification, but tax diversification is still a mystery to most. Essentially, the theory is to maximize tax reduction strategies and reduce taxation. My clients hear me talk about this rather frequently. One particular area where this is often overlooked is in the world of ROTH conversions.

A ROTH conversion can be an great tool for some folks, but a conversion for others may not be all that it is cracked up to be. This is where tax diversification comes into the picture. The beauty of tax diversification is that it gives you choices. Since we don’t know where tax rates will be when we retire, having options of pulling money out where it makes the most sense is a wonderful way to manage our tax liability. Here’s how it fits into the ROTH conversion topic.

For example, I have a 45 year old client that has a small IRA ($50K) that for many advisors would look ripe for converting. This client also makes a ROTH contribution every year (due to restrictions) and has a nice nest egg in his ROTH account. So, let’s move ahead to retirement when the client is taking distributions from these accounts. If the only funds withdrawn are from the ROTH account, he will leave tax savings on the table. The tax code allows for a standard deduction and personal exemption that will eat up some taxable income every year. To chew up the income reduced by the standard deduction and exemption, the traditional IRA is a great place to pull from. Currently, a single tax payer, age 65 earning social security but no other taxable income, can withdraw roughly $10,750* from an IRA and not pay tax on that withdrawal.….all while still withdrawing from the tax-free ROTH. One of the great sins in tax planning is to let free money go to waste.

Without making this more complicated than it needs to be, here is an easy way to think about it. For the current tax year, the 65 year old tax payer in the example above can pull $10,750 from a traditional IRA tax free. This taxpayer also received the tax deduction on the money when it was originally contributed to the traditional IRA, which saved tax dollars at the time of the contribution. This creates the best of both worlds for this money: it’s contributed on a pre-taxed basis and is withdrawn tax free. This is tax diversification at its best.

Let’s go back to my original example. Essentially, we learned that my client doesn’t need to convert this IRA. He will be able to capture the same result in retirement as if he had converted…..but just a piece at a time. If he had converted his $50k IRA to a ROTH, it would have cost him $12,500 in taxes. This truly illustrates the magnitude and complexity of the ROTH conversion debate. It also points to the value in proper tax planning and creating tax diversification. So if you are considering converting an IRA to a ROTH, you should ask yourself if you are improving or reducing your tax diversification for retirement. Do you have a tax diversification story or idea you would like to share? I would love to hear from you!

*This is a generic example to illustrate a point. Your situation may be different, so you should consult a tax professional.

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2 Responses to Tax Diversification and the ROTH Conversion Debate!

  1. Parag says:

    When I did the conversion of a traditional IRA to Roth IRA in 2009, I didn't look at how that conversion might impact the taxation of our Social Security income. I have now discovered that 85% of our SS benefits will be taxed for 2009. In 2008, our income was so low that we had not been required to pay any taxes on our SS benefits.Roth conversion

  2. ParagI'm sorry to hear that your conversion was not what you hoped. Tax planning is often missed when contemplating a ROTH conversion. The good news is taxable income will be short lived and your SS benfits will only be taxed for the year of the conversion….unless other circumstances apply. Cheers!

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