First, roughly 25-30% of our retirement investments are currently in 'Roth' or after-tax accounts. The rest is in traditional, or pre-tax retirement savings accounts. So even though it may look like we have a lot saved for retirement, a large chunk of the accounts are what I refer to as phantom money. Sure, the money is in my name and I can invest it however I please, but even if I were over age 59 ½ and were to go and withdraw it, I'm going to have to give a good sized chunk of it to the IRS for taxes. Our Roth IRA's, on the other hand, are 100% OURS.
At this point you may be thinking "Ok, I get it, putting money in Roth means that it's all yours, but that still doesn't make sense why you would willingly pay a bunch of taxes just to satisfy your inner three-year-old saying 'mine!' It's not like the IRS is asking for the taxes, they're cool with you deferring them."
Actually, it's a lot more than just that. You see, by paying some taxes NOW, I actually end up paying A LOT less taxes down the road. How's that?
It used to be that only those who earned under $100,000 per year were eligible to convert to Roth. For the past several years, though, that limit has been waived, allowing anyone with pre-tax accounts to be able to convert to Roth, regardless of income level. I haven't been able to find any hard stats on this, but from my experience, removing this limitation created a bit of a windfall for the IRS as many investors began converting large amounts of pre-tax investments to Roth IRA's, opting to pay taxes now and continue investing tax free. When I was a financial advisor, I helped several clients convert balances over $1,000,000 to Roth IRA's.
Even though this decision reduced the amount of refund we'll be receiving from the IRS this year, I didn't convert so much that we won't be receiving a refund. By having the taxes for the Roth conversion paid from our tax refund amount, we're able to pay these taxes without disrupting any other part of our normal monthly budget. We try to minimize the amount of refund we receive each year, but it has been challenging as every year is a bit different (ratio between salary and bonus pay, number of children, etc.). Our plans for now are to convert some of our pre-tax accounts to Roth each year, paying the taxes out of pocket and not touching the retirement accounts themselves to cover the taxes.
I only have two regrets related to this Roth conversion. First, I regret not having converted anything in previous years. I really only skipped 2013 and 2014 since prior to that we didn't have any pre-tax money outside of 401k's. If we had converted in 2013 and 2014, we would have converted before the market went up and would have been able to convert more of the account for the same tax bill. The second regret is that I waited until December to do the conversion. In this case, it didn't really matter when I did the conversion since the market ended the year roughly the same as where it started, but if it had gone up a lot in 2015, the decision to wait could have cost me. That being said, now that the market has come down a bit this past month, I plan to do my annual conversion soon rather than wait until the end of the year. When you convert to Roth, the amount you're taxed on is the value of whatever you convert when you do the conversion. So, if I convert $5,000 now, I'll pay taxes on $5,000 of income no matter what the investment is worth at the end of the year.
The difference in taxes shown above is showing the advantage of a $5,000 Roth conversion, and it clearly makes sense. The extra $5,000 in income didn't push us into a higher tax bracket and we had the money to pay the taxes out of pocket. Since we don't have the cash to pay taxes on an extra ~$200,000 in income, we'll be converting the rest of the accounts a little at a time, hopefully saving ourselves a lot more than just the $12k shown above. The decision on whether to convert to Roth really is just a question of when do you want to pay taxes. My choice is to get them out of the way and invest as much as I can in tax free Roth's.