Listen to Scott and Pat help a caller decide if he should start converting his IRA to a Roth based on his taxable income now and in retirement.
Scott Hanson: Let's talk to Jeff. Jeff, you're with Hanson McClain.
Jeff: Unh huh.
Scott Hanson: Hi, Jeff.
Jeff: In a few years, I'm going to be rolling the content for my 401(k) into a traditional IRA. Can I do an annual conversion of a certain amount of money each year into a Roth IRA?
Scott Hanson: Yes, and that's actually the way you'd want to... Are you retiring in a few years? Why in a few years?
Jeff: In a few years, when I retire.
Pat McClain: So why are you not making contributions to the Roth 401(k) now?
Jeff: Well, I thought about doing that, but it would increase my taxable income.
Pat McClain: So that's the question that needs to be asked, which is: What is my taxable income now, and what will my taxable income be in retirement? And then when you convert from an IRA to a Roth IRA, you have to do that calculation every year, in order to not put yourself up into a higher marginal tax rate. So do you know what your taxable income will be in retirement?
Jeff: Well, my pension would be probably around $50,000 a year.
Pat McClain: Okay.
Jeff: That I make now.
Pat McClain: Will you be receiving social security?
Jeff: Not at that point, no. I plan on working part time after I retire from the company I'm with for additional income and then probably tapping into some of the funds that I have until I do get social security age.
Pat McClain: And how much do you make now?
Jeff: About $120,000.
Scott Hanson: Yeah, okay. So you're at the right strategy, pre-tax right now. You're at a stall in 25% tax bracket, taking the deduction at retirement. You're thinking the right way. You really are. You talk about doing part-time work, but let's say you have a year where you don't, you might choose to convert some to the Roth IRA.
The way our tax structure works, it's very progressive. So if you have very low income, you're not going to pay any income taxes. If you're making millions, 39.6% Federal tax, and another 3% ObamaCare tax on top of that, plus 13.3% in California. So you'll pay over half income tax, which is a lot of money. And the way these tax brackets work, they're big jumps. It's not like we go from 0% to 39.6% by adding 1%, as your income goes up. There will be a tax bracket at 15%, which the majority of Americans are in the 15% or lower tax bracket. It jumps from 15% to 25%. So it doesn't mean once your income goes up to that level, you pay 25% on everything. It means those next dollars are taxed at that 25% level. Then it goes 28%, bumps up from there.
So the proper kind of planning, which you are thinking about, Jeff, which is wise, is on an annual basis, if you're in that position where you're in a 15% tax bracket and you've yet to bump up to the 25% tax bracket, which sounds like it's exactly your situation in retirement, you might say, "Look. I can convert $12,000 from my IRA to a Roth IRA, today, and I know I'm being taxed at 15%."
But it doesn't matter what you've read about articles or tax rates going up or they're going down. You know for yourself that this year you can lock in a tax at 15%, whereas you'll be at a 25% or higher in the future.
Pat McClain: And that's exactly what you want to do, is you want to go through that exercise every year.
Jeff: Yeah, and that's what my plan was, to see how far I am from the next tax bracket, not how much I convert that year.
Pat McClain: Correct, absolutely.
Scott Hanson: That is the right way to look at it, Jeff.
Jeff: Thank you.
Scott Hanson: I appreciate your call.