Updated: Feb 1, 2021
At the end of last year, after I had done tax planning for all my clients, I finally got around to analyzing my own situation. Typical ‘cobbler’s kids with no shoes’ behavior, waiting until the last minute to take care of myself.
One of the primary considerations when doing tax planning is to evaluate how much income you have in the current year relative to other years. Our tax system is progressive which means as you earn more, your tax rate goes up. Let’s say you earn $100,000 salary as a single person. The first $10,000 is taxed at 10%, the next $30k is taxed at 12%, the next $45,000 is taxed at 22% and the last $15,000 would be taxed at 24%. Tax deductions erase the highest taxed income first, so if you had deductions that totaled $15,000 it would essentially wipe out the income taxed at 24%.
In years when your income (and thus your tax rate) is higher than usual, it is beneficial to consider tactics like deferring income or advancing deductions. Conversely, in a year with relatively low income, it can make sense to advance income and delay deductions.
As I reviewed my own tax situation, I recognized that 2020 was likely to be a lower-than-average year for income as I was in the process of building my business. I also knew that tax rates in 2020 were lower than they had been in a long time and that these lower rates may not survive under a new presidential administration. With that in mind, I considered whether I should intentionally create income to pay taxes at lower rates. I could do that by selling stocks that had gone up in value, the gains on which would be taxable. I could also convert some or all my IRA to a Roth IRA.
A Roth IRA conversion is simply the act of moving money from your regular IRA to your Roth IRA. Generally, if you move $10,000 from your IRA to your Roth, you pay tax on $10,000. The advantage is that your $10,000 can continue to grow inside the Roth IRA and if you follow the rules, you will never have to pay tax on that income again no matter how much the initial $10,000 grows. In other words, a Roth conversion is often a decision to pay taxes voluntarily today, hopefully at lower tax rates, so you can avoid higher taxes in the future.
After considering all these factors, I concluded that in my case, a Roth conversion would be advantageous. I understood that I would be paying a very low tax rate, both compared to what I would normally pay and compared to historical rates. I knew this would enable me to capture the maximum amount of tax deductions for the year. I knew that I had a long time to benefit from tax-free growth inside my Roth IRA. I knew I had the money to pay the taxes. And yet, when it came time to proceed with the conversion, I felt an overwhelming sense of resistance.
The conversion was going to cost $4,000 and the idea of spending that money in exchange for some intangible future benefit felt…bad. Despite what I know, despite having walked through these exact same scenarios with clients, I still struggled with the idea of “spending” $4,000 that I did not have to spend. The part of me that often hesitates to spend, the part of me that fears scarcity, the part of me that likes money in the bank, wanted nothing to do with this strategy. I dismissed the facts and clung to feelings.
What I am describing is the internal conflict that occurs when reasoning collides with emotion. I had more than enough information to conclude that paying the tax was the wisest financial decision. I could easily list out all the justifications, as I eagerly would have if I had been recommending this strategy to someone else. And yet, somehow, because it was my own money, none of that reasoning was good enough. The tax calculations and spreadsheets were useful but none of them addressed my real concern – how it felt to be parting with $4,000.
You may be thinking how irrational this sounds and I could not agree with you more. That is the point; I was not being rational. And for better or worse, part of being human is being irrational.
Our financial decisions don’t get made in a part of our brain that is sequestered from the influence of emotion. It is why we do things like buy our children stuff because we feel guilty, work years longer than we need to because we fear running out of money or avoid asking for a raise because we question whether we are worth it. It is why I hesitated to do something that was obviously financially beneficial.
No one is as impacted by our financial decisions as we are and that makes it exceedingly difficult to be objective about our money. But we can turn to others for an outside perspective. The same way we go to an expert to supply us with the knowledge we might not have, we can also turn to them to give us the perspective we do not have. This emotional objectivity is one of the most under-valued aspects of working with a financial planner. It is also the reason that many financial professionals have a financial planner of their own.
Ultimately, I took all my facts and feelings to a close friend who is also an advisor. We talked it out and I moved forward with the Roth conversion. It did not make writing a $4,000 check to the IRS any more enjoyable, but it did keep me from passing up a great financial opportunity. The next time a financial opportunity knocks on your door, who will help you decide whether to answer?
As originally published on Forbes: https://www.forbes.com/sites/danielleseurkamp/2021/01/27/why-i-nearly-passed-up-saving-thousands-in-taxes/?sh=3e66f3c7417c