Roth Conversion Makes Sense at Today’s Low Tax Rates

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Roth Conversion Makes Sense at Today’s Low Tax Rates

For a long time, converting a regular IRA to a Roth IRA was a relatively low-risk option. If you changed your mind later, you could always go backwards. That came to an end with the tax package signed by former President Trump in December 2017.

Beginning with the 2018 tax year, the Act eliminated the opportunity to “recharacterize” a Roth conversion into a conventional, SEP, or SIMPLE IRA. It performed the same thing with Roth IRA monies transferred from 401(k) and 403(b) accounts. There was a limited window until October 15, 2018, when you may reverse a 2017 Roth conversion. The deadline has, of course, gone.

Key Takeaways

  • You lost out on reduced tax rates if you converted to a Roth in 2017. It’s too late to undo that transformation.
  • If you have a regular IRA or 401(k), today’s record low rates should entice you to switch to a Roth.
  • The revised tariffs are valid until 2025.

On the plus side, we now have historically low tax rates. So it makes more sense than ever to convert a standard IRA or 401(k) to a Roth and keep it there. Unless, of course, you expect tax rates to go much lower than the 10% to 37% range that is now in place until 2025.

Effect of Tax Rate Changes

Traditional IRAs allow investors to contribute before taxes and pay conventional income tax rates when the money are withdrawn in retirement. A Roth IRA provides identical advantages, but in reverse. You pay regular taxes now so that you may make tax-free qualifying withdrawals later.

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If paying Uncle Sam now results in a reduced total tax obligation, switching to a Roth makes the most sense. Consider a married couple that changed their $200,000 conventional IRA account, which was fully comprised of pre-tax funds, into a Roth in 2017, prior to the Tax Cuts and Jobs Act. Assume they also earned $100,000 in other taxable income.

Their $200,000 account would have been subject to a 33% income tax rate in 2017 under the prior tax rules. (For tax purposes, any previously untaxed money that you categorize as a Roth is added to your adjusted gross income.) The conversion alone would result in a payment to Uncle Sam of $66,000. Meanwhile, income of $200,000 is only taxed at 24% in 2021 for married couples filing jointly.

Individuals’ marginal tax rates were reduced under the Tax Cuts and Jobs Act (TCJA). The TCJA’s increased tax rates are expected to expire in 2025. The tax rates for 2022 are shown below.

2022 Tax Rates
RateMarried Joint ReturnSingle IndividualHead of HouseholdMarried Separate Return
10%$20,550 or less$10,275 or less$14,650 or less$10,275 or less
12%Over $20,550Over $10,275Over $14,650Over $10,275
22%Over $83,550Over $41,775Over $55,900Over $41,775
24%Over $178,150Over $89,075Over $89,050Over $89,075
32%Over $340,100Over $170,050Over $170,050Over $170,050
35%Over $431,900Over $215,950Over $215,950Over $215,950
37%Over $647,850Over $539,900Over $539,900Over $323,925

Unwinding the conversion before October 15th could have been a prudent decision. If the couple had done the Roth conversion again in 2018 at today’s lower rates, they may have saved a lot of money, provided their account balance remained the same. Similarly, in 2021, a couple in the same tax bracket might convert a conventional IRA or 401(k) and pay for the conversion at today’s lower rates.

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To Wait or Not to Wait

Remember that the individual income tax cuts signed into law are scheduled to last until 2025. Congress may either continue the tax cuts or pass a whole new tax bill. It is difficult to forecast.

One certainty is that current tax rates are quite low. And, if you continue to contribute money and your money continues to make money, your account will expand. Every year, it will become more difficult to pay the income tax burden associated with a Roth conversion.

The main advantage of a Roth is that you should never owe money on the account again. As long as you take qualifying distributions, you will owe no additional taxes on the principal or profits when you begin withdrawing the money, probably when you retire.

This is in contrast to a standard IRA or 401(k), where you pay income taxes on both the principle and profits when you withdraw.

Also, bear in mind that you are not required to convert all of your money at once. You may reduce your tax bill by spreading out the conversion across many years and converting just enough to remain in your current bracket.

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