How Roth Conversions Can Help You, Your Surviving Spouse, and Your Heirs

Did you know Roth conversions are an important consideration in nearly every financial plan, especially for married couples? Read on to understand why.
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Whenever I have an initial conversation with a potential new client, I mention my view that taxes and investing are “joined at the hip.” By this, I mean taxes are an important consideration in our personal finance decisions. Investment-related decisions have tax consequences. We don’t want to let the “tax tail wag the dog,” but we don’t want to ignore taxes either. They’re important. Reducing our tax bill can save us money today or leave us with more money to spend in the future. In today’s blog, we discuss some benefits of Roth IRAs.

I’ve written about Roth conversions before (see here and here). They are an important consideration in any financial plan. If you want to read more about Roth IRAs, this article discusses some of the pros and cons of Roth IRAs. Read this one if you want to learn more about how to do a Roth conversion.

Traditional IRAs vs. Roth IRAs

Individual Retirement Accounts (IRAs), 401k’s, 403b’s (collectively IRAs) and Roth IRAs, Roth 401k’s, Roth 403b’s (collectively Roth IRAs) are all tax-deferred accounts. The primary difference relates to when you pay your taxes.

With an IRA, you don’t pay any taxes on the amount you contribute. You don’t owe any taxes on the growth in your account either. But you pay taxes at your ordinary income tax rate when you withdraw funds from the account.

With a Roth IRA, you pay taxes on the amount you contribute. Your account can grow tax-free, too. You also don’t pay taxes when you withdraw money from the account.

Initial Funding of Roth IRAs

Unless you’re someone like Peter Thiel, It’s hard to build a large balance in a Roth IRA through contributions. You can only contribute up to $6,000 a year ($7,000 if you are 50 or over). Income limitations also apply. Some companies have a Roth option in their 401(k) or 403(b) plans. Others don’t. If yours does, you can contribute up to $20,500 this year ($27,000 for those 50 or over).

Those with income over the contribution limit could complete backdoor Roth conversions to get around the income limits for IRA contributions. (In short, a backdoor Roth involves making a nondeductible IRA contribution and then converting those funds to a Roth IRA. In general, you should only attempt backdoor Roth IRAs if you do not have any funds in traditional IRAs or rollover IRAs. Having such accounts can make your backdoor Roth IRA conversion taxable.

Proposed legislation included in last year’s Build Back Better Act eliminated Backdoor Roth IRA contributions effective December 31, 2021. But that legislation didn’t pass. We don’t know if the legislation will be revived. If it is, we don’t know when it will be effective. It could be effective beginning in 2023. It could be effective at the date it’s proposed. Congress could backdate any rule change to the beginning of the year. That seems unlikely though.

The other way you can fund your Roth IRA is by converting funds in your traditional IRA to a Roth IRA. For a Roth conversion, you pay tax on any untaxed amounts that you convert.

Why Have Funds in a Roth IRA

There are many types of diversification. Most people have at least heard of the term asset allocation. This centers on holding assets across multiple asset classes to diversify your investments and reduce risk. It’s also important to consider asset location, which focuses on which types of assets should be held in which types of accounts from a tax perspective.

You also want to diversify your account types. By this, I mean you should try to have accounts that are treated differently from a tax perspective. This can allow you to better manage your tax bill. Withdrawals from taxable accounts, IRAs, and Roth IRAs are all taxed differently. By considering your tax situation in any given year, you can make your withdrawals more tax efficient. How? You can balance the amount you withdraw from each different type of account. That can help you minimize your tax bill. The potential benefits of Roth IRAs include a lower tax bill over time

Please note that in this blog, I am not addressing Health Savings Accounts (HSAs). HSAs can provide a triple tax benefit, which can make them even more tax-efficient than either IRAs or Roth IRAs.

Tax Benefits of Roth IRAs

Roth conversions can help you increase the amount you hold in a Roth IRA. They can also help you better manage your tax bill. Let’s talk about how. The following table shows the 2022 tax brackets for different filing statuses.

In a historical context, a tax rate of as much as 24% is low. I like to discuss the idea of bracket stuffing. What I mean by that is, based on your current income and assets, determine the maximum tax rate that you’re willing to pay. I find that clients are usually okay with paying taxes at a 22% or even 24% rate. (For some it’s only 15%.) It all depends on your situation.

I want to compare the rate you will pay today to the rate you might pay in the future. Please note that I do not, in any way, pretend I have a crystal ball that allows me to predict future tax rates with any degree of certainty. I prefer to default to whatever I currently know about tax rates. If rates change in the future, I will change my views to reflect those changes.

We know that last year’s proposed legislation attempted to increase tax rates. It didn’t pass. We also know that the tax rate changes that were implemented at the end of 2017 sunset at the end of 2025. Then we go back to the old rates (2017). You can find those rates in the following tax table – which could be indexed for inflation if it ultimately applies.

You’ll notice that the 22% and 24% brackets disappear. We go from 15% to 25%. Even more importantly, let’s look use an example to consider what could happen to your tax rate.

Benefits of Roth IRAs for Married Couples

For purposes of this discussion, I’m going to focus on Married Individuals Filing Joint Returns. Consider a married couple that expects to earn $250,000 of taxable income in 2022. Their marginal tax rate – the tax rate paid on the last dollar of income – will be 24%. In 2026, at that same level of income, their marginal tax rate will increase to 33%.

Let’s also assume that this couple regularly maxes out the contributions to their IRAs. Based on their financial plan, we expect that they will have $2.0 million in their IRAs when they retire. (Please note: I understand these numbers may seem high. But they are more achievable than you think if you can earn a good income and save diligently toward retirement.)

Now, let’s project that they will receive combined annual Social Security benefits of $70,000. A few years into retirement, their required minimum distributions (RMDs) could be $100,000 or more. Let’s also say that they have $10,000 of other income. That could put them into the 28% tax bracket. That’s 4% higher than what they pay today.

Benefits of Roth IRAs to a Surviving Spouse – Usually the Wife

More often than not, one spouse outlives the other. Sorry guys, but usually our wives outlive us. What happens now from a tax perspective shows another benefit that comes from having your money in a Roth.

Most of the income you receive in retirement as a couple will go to your wife after you die. Your wife gets the higher of the two Social Security benefits. We usually pass our IRAs to our spouses first. That means the RMD won’t change all that much. If she’s younger, her RMD may fall a little.

Assume that your Social Security benefits were about the same. That leaves her with $35,000 of Social Security income. For purposes of this discussion, let’s leave her RMD at $100,000. Let’s leave other income at $10,000, too. That’s $145,000 of income. If we use the 2017, tax table, she’ll still be in the 28% tax bracket. Once again, paying tax on a Roth conversion at a 24% rate today saved taxes over the long term.

Benefits of Roth IRAs to Your Heirs

Some of us want to leave money to our children after we’re gone. Some don’t. Others say if some money is left after they’ve passed it will be nice, but it’s not a priority.

With the passage of the SECURE Act on December 27, 2019, the rules for inherited IRAs changed. In general, the beneficiary of a non-spouse IRA has 10 years to distribute the funds from the IRA. Withdrawals from an IRA are taxable. This can create what I like to refer to as a “tax bomb” for your beneficiary. The additional income can put him or her – or their family – in a higher tax bracket.

If your beneficiary inherits money held in a Roth IRA, they still have only 10 years to distribute it, but they won’t pay any taxes on it.

Other Roth IRA Considerations (Social Security and Medicare-Related Concerns)

There are some other things to keep in mind about Roth conversions. They can have positive or negative effects on your taxable income and tax bill in other ways. You need to watch out for the negative consequences that the higher taxable income through Roth conversions can have on your tax bill. On the other hand,  Roth conversions can benefit your tax bill by reducing income in the future.

For example, you want to consider that Social Security tax torpedo. This can happen as your income crosses certain thresholds. Higher income can make more of your Social Security benefits taxable. You also want to consider the impact higher income can have on your Medicare premiums. Your monthly premiums can increase when your income rises. This increase is called IRMAA – Income Related Monthly Adjustment Amount.

On the other hand, Roth conversions will result in lower taxable income in the future. That means that your IRMAA can be lower if you properly time your Roth conversions. They can also help mitigate the impact of the Social Security tax torpedo.

CLOSING COMMENTS

Many of us have low balances in our Roth IRA accounts – perhaps you don’t have any Roth IRAs at all. The contribution limits are low. They haven’t been around that long either – they were not a savings option until 1998. That doesn’t mean that Roth IRAs should be disregarded. They can still play an important role in your financial plan. The potential benefits of Roth IRAs discussed above are important to your financial plan.

If you don’t have a Roth IRA – or only have a small amount in your Roth IRA – you can still consider Roth conversions. Roth conversions can add value to us in three different phases of our lifetimes:

  • They can lower the cost of withdrawing funds from our retirement accounts.
  • They can reduce the taxes paid by a surviving spouse.
  • The tax bill for our beneficiaries in future generations can also be lowered.

While you can have an overall intention to complete Roth conversions as part of your financial plan, you should decide how to proceed on a year-by-year basis. When I work with clients on this type of issue, I suggest that we take a closer look at their tax situation each year and decide how much we want to convert. Often, this is done during the fourth quarter as that’s when you have the best idea of your full-year income.

If you are unsure of how to complete a Roth conversion or whether it’s even right for you, please schedule a free call. I would be happy to review them with you. You are also welcome to send an email to philweiss@apprisewealth.com.

I’ll be back next week with “Apprise’s Five Favorite Reads of the Week.”

Our practice continues to benefit from referrals from our clients and friends. Thank you for your trust and confidence.

We hope you find the above post valuable. If you would like to talk to us about financial topics including your investments, creating a financial plan, saving for college, or saving for retirement, please complete our contact form. We will be in touch. You can also schedule a call or a virtual meeting via Zoom.

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