How to Optimize Roth Conversions: Why Timing is Important (Part Two)

In a previous Roth conversion article, we discussed the importance of timing when it comes to Roth conversions. There are other Roth benefits, such as not having to worry about required minimum distributions (RMDs), and being able to take out qualifying contributions and conversions at any time.  There is a danger of overpaying for that privilege. Let’s imagine a household currently in the highest tax bracket (39.6%). They plan to eventually retire to the 15% tax bracket. A Roth conversion today would cost that household more than twice as much than if they waited until they had to take RMDs. Conversely, a family that is currently in the 15% bracket might save thousands of dollars by maximizing their conversions in their current tax bracket. This article aims to discuss:

• Why a military family’s tax bracket might change over time
• When you might want to consider Roth conversions
• When you might want to delay Roth conversions
• Why you might want to hire a tax professional to help with tax planning
• Why you might never want to convert to a Roth account at all

But first, we need to have a disclaimer: This article is written for educational purposes. It is not intended to provide specific tax advice, strategy, direction or instruction. Each tax situation is unique and should be discussed at length with a tax professional. The information in this article is for educational purposes only, and should not be used as a reference. Although this article links to references as appropriate, tax authorities may change over time. Everyone should exercise due diligence before implementing a recommended tax strategy.

Why a Military Family’s Tax Bracket Might Change Over Time

There are two primary categories of reasons your tax bracket will change over time. Let’s call the first category “Things that are beyond your control, and don’t directly impact you.” These are things that we cannot really plan for. This basically includes whatever Congress does (which isn’t a lot nowadays), future policy changes or unforeseen circumstances. It’s important to keep tabs on tax policy as it changes over time. It’s not something that you can really plan for. The second category would be “Things that you can control, or things that might directly impact you.” This includes promotions, career changes, lifestyle design, retirement and more. In other words, these are things that you can (or should) plan for. This would also include things that you can’t control, but will impact you. To contrast the two categories, let’s say the army plans to reduce its manpower by 10%. That may have an effect on you, but you don’t know if it will directly affect you. However, let’s say the army plans to cut promotions for pilots. You happen to be a pilot who is up for promotion, then you might want to plan for that contingency. In this article, we’re going to focus on the changes in the second category. So, why would a military family’s tax bracket change over time? There are four overlapping trends (let’s call them lifecycles), which we’ll look at. I’ll briefly outline them, but it’s important to note that these are vague, general concepts. There are myriad exceptions, too numerous to note in this article.  However, I’ll try to outline a few in each instance. With that said, you might want to sit down and mentally map out how these trends affect your life. Family life cycle: In the traditional family sense, you grow up, move away from home, eventually get married, have children, raise children until they leave the house, then they become empty-nesters. Today, the family life cycle isn’t nearly as straightforward. Divorces, boomerang children and middle-aged parents caring for both kids and aging parents are all the norm. Debt lifecycle: Since the amount of debt you carry directly impacts how much you can save, it’s important to mention this. Usually, people graduate from high school with little or no debt. However, they might accumulate debt in the form of credit cards and consumer debt, car loans or student loan debt. Over time, they might pay it off, but obtain a mortgage to buy a house. Eventually, as they prepare for retirement, people try to minimize debt so their accumulated savings can support their quality of life. Of course, there are outliers in both directions. Thanks to the internet, there are entire communities of people following Mr. Money Mustache and Dave Ramsey, both of whom extol the virtues of living debt-free. Unfortunately, though, there are many more people who struggle to get out of debt. This is particularly true for people who overpay for their college education and end up saddled with overwhelming student loan debt coming out of school. Economic lifecycle: Traditionally, people start off with little or no source of income. Coming from high school, they either go to college or go straight into the workforce into a low-paying job. As they accumulate experience and build their resumes, they increase their earning potential for as long as they remain in the workforce. Over the course of a working career, earnings potential generally rises…someone working in an industry is usually making more in their 50s than they were in their 20s, particularly if they invest in their career and keep themselves relevant. At some point, they might retire, either due to health reasons or because they want more time to do things of personal interest.  As they retire, they may find their cost of living has decreased, as they pay off their loans or downsize the house they once raised a family in. This usually coincides with the family lifecycle, either by design or circumstance. Most people try to plan for their eventual retirement as their family and debt obligations decrease, and as they approach financial independence. However, there are many people who decide to ‘off-ramp,’ whether it be to raise or care for family or part of a lifestyle design. Conversely, there are people who never retire, either because of passion or because they cannot afford to. Military lifecycle: This seems like a subset of the economic lifecycle (if you work after the military, your military income and pension are only a subset of your entire earnings potential). However, there are enough military-specific items to warrant addressing them separately.

• Tax treatment: Generally, the military receives preferable tax treatment to their civilian counterparts. This is particularly true during combat zone deployments.
• Multiple moves: Since most military families move every two to three years, there usually is an opportunity to relocate to a state with low or no income tax.
• Promotion opportunities: Everyone starts off at the bottom (however, as an officer, my definition of the ‘bottom’ was much different from when I was enlisted). Over time, promotion opportunities allow service members to increase their compensation. Unlike the civilian world, though, you don’t really ever take a decrease in pay (unless it’s for punitive reasons).

In order to fully understand the Roth conversion opportunities that lie before you, you probably should have a good idea of your current marginal tax bracket, and how you think it will change over time. Being able to map out your life in terms of these four concepts will help you identify opportunities to optimize your Roth conversions. With this framework in place, let’s look at your life as a series of one-year intervals. This way, we can evaluate each tax year and make a decision. Your decision is going to be simple:

• Make a Roth conversion until you reach the next tax bracket (or the next one after that)
• Push pause until next year

Remember, just because you don’t convert this year doesn’t mean you can’t reevaluate down the line. And you should. Even today’s 20-year retirees can have up to 30 years before having to take RMDs on a traditional plan. Let’s assume that our goal is to maximize Roth conversions at a lower (relative to the rest of your life) tax rate, and to avoid conversions at a higher rate. With that in mind, let’s look at when you should consider Roth conversions, and when you should avoid them.

When to Consider Roth Conversions

• When you’re in the 15% tax bracket or lower, always fill up to the next tax bracket. According to 2017 tax rates, this includes:
  • Single: $37,950 and lower
  • Married filing jointly: $75,900 and lower
  • Head of household: $50,800 and lower

Using 2017 pay tables, most enlisted families and some junior officer households would qualify as members of the 15% tax bracket. Of course, this doesn’t include special pays, incentives or bonuses, nor does it include tax-free compensation for combat zone deployments, so you should take them into consideration for your situation. It also doesn’t include deductions and exemptions, which you can guesstimate by looking at your previous year’s tax returns. Finally, it also doesn’t include other circumstances that we’ll discuss momentarily, so you should consider this a starting point. However, you shouldn’t just blindly convert everything at one time, particularly if you have a large amount of money saved in a traditional account. When you pay close attention to your LES, you should be able to project out how much of your IRA you can convert to a Roth before you hit the next (25% tax bracket).

• When you’re deploying for a significant time to a combat zone. What’s better than paying 0% on your income? Paying 0% on your income and paying 0% for a Roth conversion.

If you spent an entire calendar year in a combat zone, you would likely have zero taxable pay (unless you’re an officer whose compensation is more than that of the senior enlisted of any of the services). However, even if you had some compensation, you might still have zero taxable pay once you calculate exemptions and deductions. Once you add in credits, you’re looking at a significant amount of income that you won’t pay taxes on. For example, an E-7 deploys to a combat zone for a full calendar year. He has a wife and three children, 12 and younger. Let’s assume he has no bonuses, incentive pays or anything other than allowances and hostile fire pay/imminent danger pay. Assuming his wife does not work outside the home and they have no other sources of income, they will have:

• $4,050 in exemptions for each person (or $20,250 total)
• $12,700 in standard deductions (or more if they are able to itemize)
• $3,000 in child tax credit

Let’s ponder this: There are a total of $39,950 in exemptions and deductions, but no taxable income. That means you can convert at least this amount, just to get to zero. Every dollar above this is taxed at a rate of 10%. However, you’ve got $3,000 in child tax credit, which means that you can convert another $30,000 before using the entire credit. That’s almost $70,000 in conversions at a 0% tax rate. This doesn’t even factor earned income tax credit or other adjustments to income, itemized deductions (to the extent they exceed the standardized deduction) or credits. If, for some reason, you needed to convert more, this couple could add another $18,650 (at the 10% rate), or up to $75,900 (first $18,650 at 10%, then the remainder at 15%). This would mean a total tax bill of $10,452.50 to convert a total of $145,850, for an effective tax rate of 7.2%. If you needed to convert more than this amount, then that’s not a bad problem to have in today’s world. Obviously, this is an extreme example…most people will probably have some taxable income in each year since most deployments cover part of one year and into the next. Food for thought.

• When you’re exiting the military and NOT immediately taking a job. What happens when you exit the military? Most people get a job. Unless they don’t.

Many people decide to take a year off, go back to school, or retire permanently. If this is the case, you might want to consider where your income will be compared to when you finish school or re-enter the workforce. If you’re permanently retired, you might want to consider your tax bracket, and whether you can make reasonable conversions over time.

• When you move from a high-income tax state to a low (or no) income tax state. When calculating your Roth conversion liability, it’s important to consider state tax implications, as well.

For example, Maryland income tax is based upon a sliding scale which ranges from 2% to 5.75%. For a couple who is already making $50,000 per year, a $20,000 Roth conversion would cost an additional $950 in state taxes alone. If you’re expecting orders to Florida (which has no income tax), you might want to consider this in your tax planning. If you’re planning to retire to a no income tax state, even better. Before you retire, you should at least have some idea of which states tax military pensions.

• If you’re getting a promotion pushing you into a higher tax bracket. This might not be much of a consideration for most enlisted families, or even junior officers. However, if you’re selected for promotion, you should see how that new paygrade will impact your future tax situation. Since this is a permanent (hopefully) pay raise, you’ll want to take advantage of your lower tax liability before your promotion.

When You May Want to Delay a Roth Conversion

Below are some areas where you might want to consider whether a Roth conversion is worthwhile. Most of these are taxable events that might push you closer to that next higher tax bracket. However, two caveats:

1. Just a consideration. It doesn’t mean if one of these things holds true, that you shouldn’t do a Roth conversion. However, you should take the time to carefully understand the tax implications of the event, so you can decide what your Roth conversion should look like.
2. It’s not now or never. An event might lower this year’s conversion amount, or push you out of your desired tax bracket altogether. However, just because it happened this year doesn’t mean you can’t revisit it next year.

With that said, let’s look at some situations where you might want to hold off, or at least take a closer look.

• When you’re expecting a taxable bonus. For many people, this might not be an issue. I went an entire career without having to worry about extra money. However, if you’re in a career field that is bonus-heavy, you’ll want to consider the timing amount of your bonus payments when making your Roth conversions, particularly if you’re close to the next tax bracket. This is particularly true for reenlistment and retention bonuses, where a significant amount might be paid up front, with the remainder spaced out over the remaining years.
• When you’re selling a rental property. I always advise people to have their taxes professionally prepared by a CPA or enrolled agent in the year they sell a rental property (sorry, H&R Block doesn’t cut it). When you sell a rental property, you’ll likely recapture depreciation that you were entitled to. This will impact your tax return. Calculating the recaptured depreciation and the tax liability isn’t that straightforward. When selling a rental property and performing a Roth conversion, I highly recommend you consult a tax professional so that you can properly calculate how much you should convert (see below).
• When you’re expecting significant capital gains. Capital gains tax includes sales of property or investments and is captured under Schedule D on your tax return.  Although capital gains are given preferential tax treatment, they do raise your taxable income, which directly impacts your tax bracket & how your Roth conversion is taxed.  However, if you’re selling a home, and the entire gain is eligible to be excluded under Section 121, this does not apply.
• When you’re retiring from the military AND you’re taking a job where you expect higher income. That first year out of the military is pretty hectic. You’ve got a lot going on, and Roth conversions are probably the last thing on your mind. Since it normally takes a year or two for post-military life to seem normal, odds are high that you might miscalculate that first year’s income and inadvertently overpay. What you might consider is maximizing your Roth conversions (if it makes sense) in your last full year, then taking some time to see where you end up, tax-wise.

If you end up in a permanently higher tax situation, then that’s a good problem to have, and we’ll discuss what options you might have below.

• When you’re relocating to a state with higher income taxes. This isn’t an all-stop. Instead, just keep in mind the implications that state income taxes have. For people who might not want to establish residency in a non-income-tax state (to obtain in-state college tuition for their children is a common reason), you may want to take a pause and re-evaluate.
• If you have a combination of deductible and non-deductible IRAs to convert. This might have happened to someone who was diligently contributing to their deductible IRA, then reached their IRA deductibility limit. When this happens, you can still contribute to your IRA, even if you cannot deduct that contribution from your income.

While the IRS allows conversion of non-deductible IRAs (also known as ‘backdoor’ Roth IRAs), having pretax and non-deductible accounts creates some complexity. The IRA aggregation rule forces a pro rata conversion of ALL IRA accounts. For example, let’s say you have $80,000 in a pretax IRA (you took deductions on your tax return) and $20,000 in a non-deductible (you did not deduct from your tax return) IRA. Let’s assume you want to make a Roth conversion of $10,000 this year. You cannot simply take $10,000 from the non-deductible IRA (which you already paid taxes on, and could consider a “back door Roth”). Instead, you must take a prorated portion from each account. In this case, that would be $8,000 from the pre-tax account and $2,000 from the non-deductible account. You would pay taxes on the $8,000 as part of the conversion. Why you might want to hire a tax or financial professional to help.

• Tax planning. This article (over 3,000) words, is focused on one very small segment of tax planning. Tax planning is not very intuitive, and it can be messy. More importantly, it’s an iterative process. You have to consistently update your planning as changes happen in your life.  Roth conversions are a central (but not the only) part of the tax planning process.
• Understanding what your tax liability SHOULD be. You can glean a lot of information from the crowd and come up with your own sense of what right looks like. However, WebMD is no substitute for an annual checkup with your doctor. Likewise, you will never see your tax situation from a professional view unless you hire a professional.
• Second set of eyes. Even if you’re 100% right, you’re probably going to miss something. That simple omission could cost you hundreds (or thousands) of dollars.
• Tax-preparation software. The tax code is complex. Turbotax and H&R Block software does a good job for the average tax prep client (think 1040 EZ, no itemized deductions, no investments). However, as tax situations become more complex, the likelihood for errors and omissions goes up. Tax practitioners use better tax software, not just for tax preparation, but for tax planning. This allows them to help you with your tax planning to a far better level of accuracy.

Why You May Never Want to Convert to a Roth at All

There are many compelling reasons to convert your accounts to a Roth. However, there are some important reasons why you might want to hold off. There are also reasons you might consider not converting at all.

• You’ll be in a permanently lower tax bracket than your current one. If you’re in (or planning to be in) the 28% or higher bracket, you should probably look at what your life will look like when RMDs hit. More likely than not, you’ll be in the 15% bracket, or fairly close to it. Do you really want to pay higher taxes now, just to avoid a 15% tax hit down the line?
• You might choose to take distributions before RMDs hit. There’s a nice window of opportunity between the ages of 59 1/2 and 70 1/2, where you can, but don’t have to take distributions. If this window of opportunity aligns with your retirement goals, you may find that taking distributions might allow you to retire at an earlier age. After all, it’s taxed in the same manner as your wages are…except you’ve already earned this money. You can always look at this period as an opportunity to maximize Roth conversions at a lower tax bracket.
• You have charitable goals. For those who are charitably inclined, tax planning should be a focal part of your life. Not just to avoid paying taxes, but simply to put more of your money to work for the charitable efforts you want to support. One of the most powerful ways to do that is through Qualified Charitable Distributions (QCDs).

Simply put, a QCD is an otherwise taxable distribution from an IRA that is paid directly to the charity.  You don’t pay taxes on the distribution. Also, a QCD can satisfy part or all of your RMD requirement (up to $100,000 annually). If you were already planning to give money to charity, it doesn’t get any better than that. You don’t pay taxes on the money as it goes in, grows in an IRA, or goes out.

• You’re planning for longevity. I generally don’t like annuities. With that said, I’m going to talk about them for a second. To accommodate the current aging trend, the insurance industry has created longevity annuity contracts (also known as qualified life annuity contracts or QLAC). When operating inside an IRA, a QLAC would allow the deferment of RMDs until up to age 85.

Why would you want to do this? You might not. After all, QLACs don’t avoid taxes, they simply defer them. However, the purpose of an annuity is to provide guaranteed income. For those people worried about outliving their money (and who don’t expect to rely upon their RMDs to support their active retirement lifestyle), a QLAC might be an option, particularly as a hedge against long-term care expenses. While understanding the benefits and drawbacks of a QLAC is beyond the scope of this article. Each of these scenarios is an item that you might want to consider as you ponder Roth conversions. While you might disagree with the premise, you should at least consider how your life will change over the course of 20, 30, or 40+ years. The most important question to consider is whether you’re paying taxes today that you could minimize or eliminate tomorrow. Just a thought.

Conclusion

Congratulations, you made it! Seriously, though, Roth conversions are a very tough part of tax planning. It’s easy to just plug away and convert to Roth accounts. However, if you want to make the most tax-efficient decisions, you’ll find that it’s harder than it looks.