When is an IRA Roth Conversion the right thing to do

When Is an IRA Roth Conversion the Right Thing To Do?

Deciding when an IRA Roth Conversion is the right thing to do is a challenging decision.

At best, an IRA Roth conversion strategy is an annual puzzle you get to figure out, hoping for the right long-term outcome of reducing lifetime taxes.

At worst, it is speculation and guesswork, effectively a hunch.

Where is that crystal ball when I need it?

At my firm, and as a financial planner, we wrestle with this question a lot. Should we do some amount of IRA Roth conversions and if we think we should, how much?

The Biggest Guess of All

We do this type of tax planning with the best of intentions but ultimately I call this the biggest guess of all.

Will we pay taxes at the time it makes the most sense by doing an IRA Roth conversion now vs. later? Will our taxable income be higher or lower in retirement? Will tax rates in general be higher or lower in the future compared to what we know for certain about this year’s or next year’s rates? These are questions I pose to my clients and ones that ultimately they/we have to answer to bring clarity on how we will proceed.

As a refresher, a Traditional IRA is an individual retirement account (R=Retirement) to which you contribute pre-tax dollars (and after-tax dollars too – the devil’s in the details) and then owe ordinary income tax later when you make any withdrawals (but not necessarily on those after-tax dollars). A Roth IRA is another type of individual retirement account where you have already paid income taxes on the money going in and then all future withdrawals are tax-free. Heads up…there are a lot of rules and details that pertain to these types of accounts, so this is a general description.

There are a lot of unknowns when it comes to lifetime tax planning. What we do know is that the tax cuts from the Tax Cuts and Jobs Act of 2017 (TCJA) are set to expire at the end of 2025.  Some tax cuts have to do with estate and gift taxation. But other cuts are centered around income and capital gains taxation. Barring any congressional action, a few key cuts will affect many people.

The standard deduction will decrease and generally, brackets will increase. See the table below.

Tax rates  2017 Married filing jointly or qualifying widow Tax rates  2023 -2025  Married filing jointly or qualifying widow
10% Up to $18,650 10% $0 to $20,550
15% $18,651 to $75,900 12% $20,551 to $83,550
25% $75,901 to $153,100 22% $83,551 to $178,150
28% $153,101 to $233,350 24% $178,151 to $340,100
33% $233,351 to $416,700 32% $340,101 to $431,900
35% $416,701 to $470,000 35% $431,901 to $647,850
39.60% $470,001 or more 37% $647,851 or more

In 2023-2025, a household that might be in the 24% bracket, could end up being in the 28% bracket only because of the sunsetting of the tax cuts. Paying taxes earlier could save 4-6 %.

So do you convert in a year that you know what the tax rates are or do you wait for the future when you really have no idea what the situation will be like? Crystal ball, what say you?

But Wait, There’s More

Other considerations can influence your decision to do an IRA Roth conversion.

Many people have large, untaxed balances in their traditional IRAs or 401ks. As time passes and those balances grow, there comes a time Uncle Sam comes a-callin’. That is called an RMD, a required minimum distribution, currently beginning at age 73 (and ultimately age 75). As balances grow, RMDs grow, which means taxes may also increase. An IRA Roth conversion strategy may help.

When planning for a married couple, when the first spouse dies, the surviving spouse will be filing as single and may be taxed at a higher rate, especially if there are large RMDs.

If you will be giving away a large portion of your wealth to charity, you can deduct donations or give away your RMDs up to $100,000 as a qualified charitable distribution (QCD). In this case, an IRA Roth conversion may not be as necessary for reducing RMDs or future income taxes.

Pros and Cons: When To Consider and When Not to Consider an IRA Roth Conversion.

Who should consider an IRA Roth conversion?
You think you will be in a higher tax bracket later than you are in now.
Your IRA investment has hit a market low (taking advantage of a timely dip in the market, perhaps).
You have heirs you wish to leave money to and want to leave them tax-free assets.
You don’t have diversified account types (taxable, tax deferred, tax free).
You have a low or no-income year or two coming up.
You are not receiving Social Security or pensions yet, which are counted as taxable income once started.
You have money in a taxable account to pay the conversion tax instead of paying from the conversion itself.
You have other losses, deductions or charitable gifts to offset the taxes due on the conversion.
You won’t need to take distributions before age 73.
You plan to move to a state with income taxes.
You can wait the 5 years required before needing to spend the conversion amount.
You can see the ticking tax time bomb that your untaxed IRA represents, especially when RMDs begin and at the death of the first spouse and filing as Single (we call that the widow’s tax).
You like the possibility of reducing lifetime taxes for yourself and your spouse.

Who should not consider it?
You’re near or in retirement and you actually need your IRA withdrawals for living expenses.
You’re already receiving Social Security or Medicare benefits (increased income from conversions can cause higher taxation on Social Security benefits and increased Medicare premiums.)
You don’t have much money in your taxable account to pay taxes on the conversion.
You plan on donating a lot of your IRA to charity.
You don’t have heirs you wish to leave assets to.
You don’t want to potentially be pushed into a higher Medicare premium (IRMAA) bracket. That’s not a fun surprise.
You just don’t want to pay earlier than you have to.

Closing Thoughts on Whether to Do An IRA Roth Conversion

What I’ve written, are my thoughts and some ideas that I’ve learned in my research on the topic in trying to best think through IRA Roth conversions for my clients.

This is what I mean by client sentiment. Some people just don’t like the idea of paying taxes now, even if they know the rates and what to expect. They take the approach that a dollar not yet taxed is money saved in the present, a “problem” that is pushed well into the future. That may be the case. It depends on so many moving variables. What do you think or believe and how does that drive our decisions year by year?

Other folks want to get it over with, pay taxes now at a rate they already know, and have tax-free, worry-free distributions in the future.

To each their own.

As recently as 1986 (the year I graduated from high school!), the highest tax bracket was 50%. Go a little further back to 1981, it was 70%. I’ve been around long enough to remember those times, even though I was a kid and didn’t have a clue what taxes were.  No one told me I might have to pay income tax on the worms I dug and sold. So, that’s not that long ago. 1963 (a little before my time) brought us a top rate of 91%. The highest of all, 1945 at 94%.  I guess, we had to pay for a couple of wars somehow. Check it out here yourself.

My takeaway? Rates definitely can go up from where they are now.

Will they? That I don’t know.

I do know that all of these situations and variables create a planning opportunity for everyone right now.

So get planning.

 

 

This is not an exhaustive list of things to consider when doing tax planning. As always this is an educational piece, not intended to be advice. Please seek the assistance of a financial and tax professional to help you with your particular situation.

Some Sources:  Taxfoundation.org, Schwab.com and Fidelity.com

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