The Value of Roth Conversions at Today’s Low Rates

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Today’s federal income tax rates might be the lowest you’ll see for the rest of your life. As a result, if you have a traditional retirement account, such as an Individual Retirement Account (IRA), a 401(k), or a 403(b) (collectively referred to as IRAs throughout), you should consider converting a full or partial Roth conversion.

Some Background

I started my career in Deloitte & Touche’s Tax Department. Every year we heard about proposed changes to the current tax laws. Shortly after any proposed legislation was published, the firm would distribute its thoughts on what the changes might mean and how you might address them. Little of that legislation became law. My takeaway: When it comes to tax planning, view current rates as remaining in effect until rules officially changing them are adopted.  

Tax rates have crept steadily lower since I started my career. In response to the pandemic, our government has provided a few trillion dollars of stimulus payments to help individuals, businesses, and hospitals manage during the pandemic. If you believe in Modern Monetary Theory, then maybe we don’t need to repay all the additional debt our government has incurred. I read The Deficit Myth several months ago. I find merits in some of the arguments, but I don’t fully embrace the theory.

Why am I bringing this up? I think tax rates are more likely to go up in the future than down. We don’t need new legislation for that to happen either. The lower rates granted under the 2017 Tax Cut and Jobs Act (TCJA) sunset after 2025. In other words, if I follow the general rule I just outlined, I should assume higher rates in the future. Absent any other changes, in 2026, we revert to the pre-TCJA rates. They were higher.

Some Roth IRA Basics

A Roth IRA differs from a traditional IRA or 401(k). You make after-tax contributions to a Roth and can make tax-free withdrawals in retirement. For an IRA, you get an upfront tax deduction, but you pay tax when you withdraw money from the account.

If you inherit a Roth IRA, distributions are tax-free as long as the Roth IRA was held for at least five years (starting January 1 of the year in which the first Roth IRA contribution was made). You still have only 10 years to withdraw the funds, but your heirs won’t pay taxes on any distributions received. (Note: if your spouse inherits your Roth IRA, it can be combined with her Roth IRA. She won’t be subject to the 10-year rule if she does this.)

If you receive distributions from the Roth IRA before the end of the five-year holding period, they are tax-free to the extent they represent a recovery of the owner’s contributions. However, any earnings or interest on the contributed amounts is taxable.

Why Consider a Roth Conversion?

If you think your tax rates during retirement will be the same or higher than your current tax rates, you should consider Roth conversions. They could be worthwhile for one or more of the following reasons:

1. You would like to lower your tax bill in retirement.

2. You expect your income will remain elevated during retirement.

3. You expect tax rates will increase over time.

4. You worry about how much your spouse will pay in taxes on required minimum distributions (RMDs) after you die.

5. You want to keep your heirs from paying higher taxes when they take distributions from any inherited retirement accounts.

Let’s expand a little on each of the above items.

1. You would like to lower your tax bill in retirement.

Ideally, you want to have multiple accounts – from a tax perspective – to draw funds from in retirement. For example:

· Health Savings Accounts (HSAs)

· IRAs

· Roth IRAs

· Taxable accounts

HSAs are the most tax-advantaged form of retirement savings as they can be triple tax-free.

You pay taxes on withdrawals from your IRA at your ordinary income tax rate.

You do not pay any taxes on withdrawals from your Roth IRA (as long as the account has been in place long enough).

For taxable accounts, you pay taxes on gains at the lower capital gains rate if you meet the holding period requirement. Having different sources of funds can help you lower your tax bill. (See also 5 Tax-Savvy Retirement Withdrawal Strategies.)

2. You expect your income will remain elevated during retirement.

If you save diligently and invest well, the value of your IRA when you retire could be high. When you reach age 72, you must start taking RMDs from your retirement accounts. That means you must withdraw about 4% of your prior-year balance at 72. This percentage increases as you age. Your taxable income also includes at least a portion of your Social Security income and any pension income you may be entitled to. A taxable brokerage account could give rise to additional income, too. Your income could exceed what you earned while you were working. Even if it doesn’t, it could still be taxed at a high rate.

3. You expect tax rates will increase over time.

As alluded to above, if asked to make a bet on future tax rates, my guess would be higher, not lower.

4. You worry about how much your spouse will pay in taxes on required minimum distributions (RMDs) after you die.

After you die, your surviving spouse’s filing status will change from Married Filing Jointly to Single. Social Security income will decrease – the surviving spouse can continue to receive the higher of the couple’s two benefits; the other is lost. Pension income, if any, may decrease. But your retirement accounts will likely transfer to your spouse after you die. Anything remaining after she’s gone will go to your children or other beneficiaries. A change in filing status with little difference in the amount received from your retirement accounts could lead to a higher tax rate. Increasing the amount of savings in a Roth IRA can help lower future RMDs.

5. You want to keep your heirs from paying higher taxes when they take distributions from any inherited retirement accounts.

The SECURE Act eliminated “stretch” IRAs. This provision allowed your heirs to base their RMDs on their estimated remaining life expectancy. The SECURE Act requires (with some exceptions) distributions to be taken within 10 years of the account owner’s death. Distributions from an Inherited IRA are taxable to the recipient. Large distributions can result in a “tax bomb” where the beneficiary’s tax rate increases because of the taxes due on distributions from an inherited IRA.

When Should You Consider a Roth Conversion?

A great time to consider a Roth IRA conversion would be in the years just after you retire but before you start taking RMDs. Why? The account holder will generally be in a lower tax bracket during this period. Since the SECURE Act increased the age for starting RMDs to 72 from 70 ½, individuals have an extra year-and-a-half to take advantage of the strategy. I like to refer to this concept as bracket stuffing. For example, after looking at the tax table for 2021, you decide you are comfortable paying as much as a 22% tax rate on your income. If your income for the year before any Roth conversions is $130,000, that means you can complete Roth conversions of up to $42,750. In other words, you recognize enough income via this year’s Roth conversions to “stuff” or fill the 22% tax bracket.

You also want to keep in mind the effect that higher income can have on your Medicare Part B premiums. Medicare requires you to increase your premiums via an Income Related Monthly Adjustment Amount (IRMAA). Your IRMAA is based on the modified adjusted gross income reported on your tax return from two years ago. As shown in the table at this link, if a married couple’s income exceeded $176,000 in 2019, then their Medicare Part B premium would increase.

Summary

Roth conversions have exploded in popularity over the last few years. Today’s low tax rates and changes to the tax laws have created meaningful benefits for those who convert their IRAs to Roth IRAs for retirement.

The hard part is not so much determining whether converting IRAs to Roth IRAs in retirement is right for you. Deciding how much to convert, and when, is much harder to determine.

Unfortunately, there is not a general answer to that question. It takes a thorough analysis of your spending, income, goals, and more to determine the best Roth conversion strategy. In other words, you need a financial plan.

When I work on financial plans for clients, I often find that Roth conversions can generate significant savings. On more than one occasion, the software I use to help prepare a plan suggests savings of $1 million or more. Of course, this figure is partially dependent on the balance of your IRA, too. If you have $700,000 or more in your IRAs, Roth conversions could add significant value for you and your heirs.

Let’s talk and see if Roth conversions are right for you.

Schedule a Call

On Thursday, March 11, I will host the next session in Apprise’s “Ask Me Anything” webinar series: “Are You Missing Roth IRA Opportunities?” In it, I will discuss the above issues related to Roth conversions as well as other issues related to Roth IRAs. Please use this link to register. You can also ask any questions you have related to Roth IRAs or any other personal finance-related topic.

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

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