You’ve probably grown tired of my endless lectures about the wonderfulness of Roth IRAs. But wait. I have a new take. You can use the Roth conversion strategy to get some insurance against future tax rate increases that I think are almost inevitable. Roth conversions to the rescue! We’ll get to the Roth conversion game plan after first refreshing your memory about the two best-known Roth IRA advantages.
Tax-free withdrawals
Unlike withdrawals from traditional IRAs and tax-favored retirement plans like SEPs and 401(k)s, qualified Roth IRA withdrawals are federal-income-tax-free and usually state-income-tax-free too. What counts as a qualified withdrawal? One that is taken after you, as the Roth account owner, have met both of the following requirements:
1. You’ve had at least one Roth IRA open for more than five years.
2. You’ve reached age 59½ or become disabled or dead.
For purposes of meeting the five-year requirement, the clock starts ticking on the first day of the tax year for which you make your initial contribution to your first Roth account. That initial contribution can be a regular annual contribution, or it can be a conversion contribution. For example, say your initial Roth pay-in was an annual contribution made on 4/1/18 for your 2017 tax year. The five-year clock started ticking on 1/1/17 (the beginning of the tax year for which the contribution was made), and you will meet the five-year requirement on 1/1/22.
Exemption from required minimum distribution rules
Unlike with a traditional IRA and other types of tax-favored retirement accounts, you don’t have to start taking annual required minimum distributions (RMDs) from a Roth account after reaching age 70½. Instead, you can leave the account untouched and earning tax-free income for as long as you live. This important privilege makes your Roth IRA a great asset to leave to your heirs (to the extent you don’t need the Roth money to help finance your own retirement).
The trifecta: Roth conversion can provide insurance against future tax rate increases
Today’s federal income tax rates might be the lowest you’ll see for the rest of your life. Thanks to the Tax Cuts and Jobs Act, the rates shown below apply for 2019 and 2020. After 2020, who knows? While the TCJA rate cuts are scheduled to last through 2025, they could end much sooner, depending on political developments. Even if they last through 2025, I’m not optimistic about tax rates in later years.
The insurance against future tax-rate increases comes from the fact that Roth account earnings can be withdrawn as tax-free qualified withdrawals. In contrast, earnings that accumulate in other types of tax-favored retirement accounts will be subject to whatever the tax rates happen to be when the earnings are withdrawn. Those rates could be a lot higher than now.
Now, you might argue that our beloved D.C. politicians could decide to do away with the Roth IRA tax-free withdrawal deal. True. But if we get to that point, many of us will be fleeing to the Cayman Islands with what’s left of our money in suitcases anyway. So, let’s not worry about the tax-free Roth earnings deal going bye-bye.
Conversion will trigger current tax hit
Understand this: a Roth conversion is not a painless exercise. That’s because a conversion from traditional IRA to Roth IRA status is treated as a deemed taxable payout from the traditional account with the money then going into the new Roth account. So, doing a conversion before year-end will trigger a bigger federal income tax bill for this year, and maybe a bigger state income tax bill too. Converting a big account could also push you into a higher tax bracket.
But if you convert this year and/or next year, you’ll pay today’s low tax rates on the extra income triggered by the conversion and avoid potentially higher future rates on all the post-conversion income that will accumulate in your Roth account. In effect, the Roth conversion strategy insures you against future tax rate increases that would otherwise hit withdrawals coming from your current traditional IRA balance plus future account earnings.
Consider a two-year conversion strategy
As stated, converting a traditional IRA with a big balance could push you into a higher tax bracket. For example, if you’re single and expect your 2019 taxable income to be about $110,000, your marginal federal income tax rate is 24%. Converting a $100,000 traditional IRA into a Roth account this year would cause about half the extra income from the conversion to be taxed at 32%. But if you spread the $100,000 conversion 50/50 over 2019 and 2020 (which you are allowed to do), all the extra income from converting would be probably taxed at 24%.
Warning: The two-year conversion strategy assumes that the current federal income tax rate structure will remain in place through next year, regardless of how the 2020 election turns out. While a retroactive tax-rate increase for 2020 could be enacted in early 2021 after the new Congress is seated, that probably won’t happen. And you can wait until after the election results are known to decide whether or not to do a 2020 conversion.
The bottom line
Low current tax cost for converting + insurance against higher tax rates in future years on income that will accumulate in your Roth account = great idea. That said, please talk to your tax adviser before pulling the trigger on a conversion, just to make sure you’ve considered all the relevant factors.
Individual federal income tax rates and brackets for this year and next
For 2019, the ordinary income rates and brackets are as follows.
| 2019 Individual Federal Income Tax Brackets | |||
| Single | Joint | HOH | |
| 10% tax bracket | $ 0-9,700 | $0-19,400 | $0-13,850 |
| Beginning of 12% bracket | $ 9,701 | $19,401 | $13,851 |
| Beginning of 22% bracket | $ 39,476 | $78,951 | $52,851 |
| Beginning of 24% bracket | $84,201 | $168,401 | $ 84,201 |
| Beginning of 32% bracket | $160,726 | $321,451 | $160,701 |
| Beginning of 35% bracket | $204,101 | $408,201 | $204,101 |
| Beginning of 37% bracket | $510,301 | $612,351 | $510,301 |
| *Head of household | |||
For 2020, the just-announced ordinary income rates and brackets are as follows (assuming no retroactive rate changes after the 2020 election).
| single | joint | HOH* | |
| 10% tax bracket | 0-$9,875 | 0-$19,750 | 0-$14,100 |
| Beginning of 12% bracket | $9,876 | $19,751 | $14,101 |
| Beginning of 22% bracket | $40,126 | $80,251 | $53,701 |
| Beginning of 24% bracket | $85,526 | $170,151 | $85,501 |
| Beginning of 32% bracket | $163,301 | $326,601 | $163,301 |
| Beginning of 35% bracket | $207,351 | $414,701 | $207,351 |
| Beginning of 37% bracket | $518,401 | $622,051 | $518,501 |
| *head of household |