My last article covered the “sunsetting” on Jan. 1, 2026, of many of the provisions of the Tax Cuts and Jobs Act, which went into effect on Jan. 1, 2018.
Unless Congress passes new tax laws during the next three years, the tax brackets from 2017 will be back in 2026, resulting in higher taxes for many people.
For people in high tax brackets, wise tax planning is essential. One strategy to counteract potentially higher taxes in 2026 is to consider a Roth conversion between 2022 and 2025. Today’s article will dive into the reasons you may — or may not — want to consider a Roth conversion.
The basics
Traditional IRAs are tax-deferred. You receive a tax deduction each year you contribute to a traditional IRA (or traditional 401(k) or 403(b)), and the money grows tax-free while you are working. At age 72 (previously age 70.5) the government requires the owner of the traditional IRA to start taking Required Minimum Distributions (RMDs). In the first year, the RMD will be approximately 3.7% of the Dec. 31 (of the prior year) IRA account value, and the percentage grows each year as the retiree’s age increases. A traditional IRA that is valued at $500,000 on Dec. 31, 2021, would have an RMD of roughly $18,500 if the owner is turning 72 during 2022. The RMD — and all withdrawals — are fully taxable as income in that year.
For most people, traditional IRAs work well. The tax-deferral is attractive during the working years, and the RMDs help pay for annual cash flow needs during retirement. Paying income taxes on the withdrawals during retirement does not cause a problem.
However, when traditional IRAs become very large, they create tax problems during retirement. One financial advisor termed this the “Retirement Tax Bomb.” This can occur for investors who saved diligently and invested wisely throughout their career. Hence the need for creative tax planning.
Roth IRAs are tax-free. You do not receive a tax deduction when you contribute to a Roth IRA (or Roth 401(k) or 403(b)). Roth IRAs grow tax-free, and when withdrawals are taken, they are not taxed. Roth IRAs do not require RMDs at any age, so the money can be left in the account to grow tax-free for many years. In my view, Roth IRAs are the best type of retirement account to own because of their tax-free status. I encourage all young people to save for retirement in a Roth IRA (or Roth 401(k) or Roth (403(b)) rather than using a traditional IRA (or 401(k) or 403(b)).
You can convert any amount of a traditional IRA to a Roth IRA in any year. There are no income limitations (as there once were). You must pay income taxes on the amount converted in the same tax year as the conversion. If you are already taking RMDs, you must take the RMD first during the year, and then do a Roth conversion, but you can do a Roth conversion at any age.
Roth IRAs have many benefits, but a major one pertains to leaving a Roth IRA to a non-spouse beneficiary such as a child or grandchild. The SECURE Act (effective January 2020) requires that money in an inherited IRA be withdrawn by the beneficiary within 10 years after the owner’s death. This replaced the previous “stretch” rules that were far more favorable to passing wealth down to future generations. The 10-year rule applies to whether you leave a beneficiary a traditional IRA or a Roth IRA. However, with a traditional IRA, the withdrawals are fully taxable to the beneficiary (as income). With a Roth IRA, they are not taxable.
Why you may not want to do a Roth conversion
- You never want to pay a dollar of taxes sooner rather than later. With a Roth conversion, you are paying taxes now (on the conversion) to move the account into a tax-free status for the future.
- Your traditional IRA is not large and will not cause you any tax problems.
- You expect to need the money within five years. (The money from a Roth conversion cannot be withdrawn for at least five years. This is true for each Roth conversion if you do them in multiple years.)
- You do not have the money to pay the taxes that will be due on the Roth conversion in the year of the conversion. It is not advised to pay the taxes from money in your traditional IRA.
- You plan to give part of your assets to a charity when you die. Leaving a traditional IRA to a charity is a wise choice because the charity will not pay any taxes.
- You expect your beneficiaries (children, grandchildren, friends) to be in a lower tax bracket than you are now when they inherit your traditional IRA. Or it doesn’t bother you that they will be required to pay taxes on the inherited traditional IRA.
- You expect your tax rate to be lower during your retirement years than it is now.
- You expect Congress to change the rules and make Roth IRAs taxable in the future.
Reasons you may want to do a Roth conversion
- You expect tax rates to be higher in the future.
- You do not want your non-spouse beneficiaries to pay taxes as they would if you leave them a traditional IRA.
- The RMDs for your traditional IRA will be significantly higher than what you expect to need in retirement.
- The (fully taxable) RMDs from your traditional IRA will trigger higher taxes and can result in higher IRMAA for you each year. IRMAA (Income Related Monthly Adjustment Amounts) is the surcharge for Medicare Part B and D premiums charged to high earners. For the highest income bracket in 2022, IRMAA increases the premium for Medicare Part B to almost $7,000 per year. Although a large RMD alone will likely not lead to the highest income bracket, moving up to a higher IRMAA bracket can be very expensive. Roth conversions can reduce Medicare surcharges because there will not be RMDs, and any withdrawal from a Roth IRA is tax-free. This can potentially lower taxes and IRMAA every year. Not having RMDs may also cause your social security benefits to be taxed at a lower rate.
- You want to convert to a Roth IRA so future growth will be tax-free rather than tax-deferred.
- You appreciate that Roth IRAs do not require RMDs so the money can be left to grow for many years.
Other factors
Because you can convert any amount in any year, you may want to convert a portion of your traditional IRA over several years. The best “windows of opportunity” for Roth conversions are after retiring, but before starting Medicare, Social Security benefits or RMDs. Other optimal times are years when your income is lower than normal, or years when your investments have declined in value.
Your specific situation needs to be considered if you are contemplating a Roth conversion, and consulting with a financial advisor or tax preparer is recommended. They can provide you with projections, showing the tax impact (now and in the future) based on several scenarios. For example, perhaps you want to consider converting $10,000, $25,000, $50,000 or more during each of the next four years. Doing your research will improve your tax planning skills, and lead you to decide if a Roth conversion is wise for you.
This article originally appeared in the Albuquerque Journal on October 3, 2022. Donna Skeels Cygan, CFP®, MBA, is the author of The Joy of Financial Security. She owned a fee-only financial planning firm for over 20 years, and retired from serving clients in November 2021. She is now writing a new book, titled Your Amazing Future: A Guide for Women Who Want More Freedom, Financial Security, and Joy. It will be published in 2023. To receive a monthly email with her latest article, please sign up here. She welcomes emails from readers at donna@donnaskeelscygan.com. Please share the article with friends, colleagues, and clients.