Three things to keep in mind when considering a Roth IRA conversion
Partial or full Roth conversions require a multifaceted analysis. The strategy is heavily dependent on individual circumstances, and recent changes incorporated in the SECURE Act — including modifications to the required minimum distribution (RMD) rules and tax implications for beneficiaries who inherit an IRA or Roth IRA — make this a good time to consider the strategy.Here are three important considerations to work through with your financial advisor and accountant when deciding whether to convert your traditional (pretax) IRA into a Roth IRA.
1. Can your cash flow support a Roth conversion?
The most attractive aspect of a Roth conversion is to begin compounding, tax-free growth on an investment that can span the rest of your (or your spouse’s) lifetime plus potentially 10 years after that. Therefore, the earlier you can convert, the better the math becomes. How early this can be done depends on your individual cash flow considerations. If you can’t pay the conversion tax using non-IRA assets, using IRA funds will reduce the amount in the Roth IRA that can benefit from tax-advantaged growth. If you’ll rely heavily on your 401(k) or IRA to fund your lifestyle in retirement, Roth conversions may be less appealing since distributions reduce the time horizon available for compounding tax-free growth. Additionally, if you’re under age 59.5 and use IRA funds to pay the conversion tax, you’ll be subject to a 10% early withdrawal penalty on the amount that gets withheld.
2. Understand your tax rates and the tax rates of your beneficiaries
The Tax Cuts and Jobs Act of 2017 (TCJA) reduced income tax rates across all filing statuses and income levels; however, the reduced rates are scheduled to sunset on Jan. 1, 2026, absent any action by Congress. For married couples who file a joint return, the top of the 24% bracket is $364,200 in 2023. Pre-TCJA, that same income level landed those taxpayers squarely in the 33% bracket. Therefore, there’s currently a three-year window (2023–2025) to potentially take advantage of a lower bracket for the same amount of income. If your current marginal tax rate is lower than your expected tax rate in the future, it could be advantageous to convert now. This is often the case for newly retired taxpayers who haven’t started drawing on Social Security and/or haven’t begun taking RMDs from their IRAs or 401(k) plans. The three-year window could provide a valuable opportunity to use up lower tax brackets via “micro-conversions” (converting smaller amounts over a longer time horizon) before your marginal tax rate potentially increases.
Roth conversions are taxed as ordinary income; however, conversions can impact the taxability of more favorable income as well, like long-term capital gains and qualified dividends. Depending on income level, capital gains and qualified dividends can be taxed at 0, 15, 18.8, or 23.8%. A Roth conversion can push other income into a higher bracket, which must be considered in any conversion scenario. If you’re collecting Social Security or on Medicare, a Roth conversion can impact taxability of your Social Security benefits and increase Medicare Part B & D premiums.
State income tax rates should also be considered in your analysis since IRA distributions are subject to both federal and state income tax. IRA owners who name beneficiaries in states other than their own must consider multiple state income tax rates. For example, a retired individual in Florida or Texas will pay no state income tax on a Roth conversion due to those states not having any state income tax. However, if they leave their pretax IRA to their child who lives in California, that child could pay up to 13.3% (2023) in state income taxes when money is distributed, especially if that child is in the prime earning years of their own career. In this example, Roth conversions can save the next generation a significant amount of income taxes.
3. Charitable and estate planning considerations
If your estate plan leaves assets to a qualified charity, including private foundations and donor-advised funds, Roth conversions may incur tax which otherwise may never need to be paid. If charitably inclined, you should consider naming a qualified charity as the ultimate beneficiary of your pretax retirement accounts. Qualified charities don’t pay income tax on retirement distributions. Therefore, leaving pretax IRAs or 401(k) plans to charity at death avoids estate tax and future income tax.
If charitable giving is not part of your estate plan and you have a taxable estate (estate valued in excess of $12,920,000 for individuals or $25,840,000 for married couples in 2023), Roth conversions can be an effective means of wealth transfer because the income tax paid on conversion reduces the taxable estate (thereby making the “cost” of converting less for those with taxable estates versus those without taxable estates). There are 17 states that have state-level estate taxes or inheritance taxes. If you or the beneficiaries of your estate live in one of those states, there’s a possibility that IRA assets could be double-taxed if the retirement account is subject to state estate or inheritance tax.
Bottom line
Roth conversions can be effective under the right circumstances. However, several variables and pitfalls must be considered — current and future income sources (RMDs, Social Security, etc.), federal and state income tax situation, potential impact on long-term capital gains and qualified dividends tax rate, taxability of Social Security, cost of Medicare Part B & D premiums, charitable intent, and estate situation. The efficacy of financial planning strategies can be altered significantly depending on laws put in place by Congress, policies of a new administration, etc. As far as Roth conversions go, you’ll only know whether you made the “correct” decision with the benefit of hindsight; however, that shouldn’t stop you from investigating the potential benefits of converting now.
