Why Roth? Why Now?
Executive Summary
Between tax law changes, new inherited IRAs distribution rules, the substantial likelihood of higher taxes in the future, and the ability to “take advantage” of lower tax brackets, this is a great time to convert assets from an IRA into a Roth IRA.
What we know…
Current Tax rates are some of the lowest rates in recent memory (the top Federal rate is currently 37% on income above $693,750 for a married couple). The highest marginal rate in 1913 was 7% when the income tax was introduced. It rose to 77% in 1918, peaked at 94% in 1944, and has fluctuated between 35% and 39.6% over the last 20 years (https://www.taxpolicycenter.org/statistics/historical-highest-marginal-income-tax-rates). The top marginal rate is scheduled to return to 39.6% in 2026. In addition, the standard deduction is substantially higher than it has been in the past ($27,700 for a married couple in 2023).
While there are income limits on who can and cannot contribute to a Roth IRA (of note—there are no income limits when contributing to a Roth 401(k)), there are no income limits on a Roth conversion. Anyone can, as long as they pay the taxes on the conversion, convert some, or all of their IRA assets into a Roth IRA.
Once IRA assets are converted into a Roth, they are never taxed again (if you wait until you are 59 ½ years old and five years post conversion). Don’t forget the 5-year rule—it can be a real “gotcha” triggering a 10% penalty in addition to the income taxes paid on the conversion.
Assets inherited in an IRA MUST be distributed from the IRA within 10 years for most non-spouse beneficiaries. This often means that people inheriting IRA assets may have to pay taxes on the assets during their peak earning years when they are in the highest marginal tax brackets of their lives. Roth IRAs also must be distributed within 10 years of being inherited; however, there is no tax on the distribution, preventing the tax man from taking up to half of the account value if one lives in a high-income tax state.
While your grandparents had to take RMDs at age 70 ½, for those of us born in 1960 or later, RMDs do not (now) start until we are 75. Waiting to start our RMDs is great; however, it leads to larger RMDs. Based on the current tables, a 75-year-old with $3,000,000 in her IRA would have an RMD of approximately $122,000 (assuming a 4% rate of return, this RMD grows to over $201,000 at age 94)—assuming she is married and the couple has no other income, this would create a Federal Tax Liability of $12,376. Assuming she dies and her husband inherits the account (and for the sake of this example, the account is worth exactly $3,000,000 the following year, and he is conveniently 75-years old) his tax liability, on the same $122,000 distribution, would be $20,008 since he would have a lower standard deduction, and would be taxed as an individual rather than as a married couple. These numbers get dramatically worse as incomes increase (social security, dividends, interest, rental income, etc.).
Considerations…
It is important to have funds available to pay the taxes on the conversion from outside of the IRA assets being converted if you are under age 59 ½ (if you pay the taxes out of the IRA that you are converting, then you will owe tax on the money you are taking out to pay the taxes as well as a 10% early withdrawal penalty).
If you are eligible to contribute to a Roth IRA (or have access to a Roth 401(k), you can avoid ever having to do conversions by making the original contributions into a Roth account.
Left over 529 plan money (if such a thing exists) can be converted into a Roth IRA (tax free) starting in 2024, up to a lifetime limit of $35,000 per student. You can only convert each year up to the Roth IRA contribution limit – with the current $6,500/year annual contribution limit, it would take 6 calendar years to fully convert up to $35,000 from a 529 plan into a Roth IRA.
If you want to make a really powerful gift to a child, match their “earned income” by putting it into a Roth IRA. A 16-year-old who puts $6,500 one-time into a Roth IRA (or whose parent or grandparent “matches” his earned income and puts it in for him) will have nearly $295,000 in 40 years, tax free, assuming a 10 percent rate of return, and no additional contributions.
“Backdoor” Roth IRA contributions—for a subset of society (and you have to fit perfectly into the box), one can make annual non-deductible IRA contributions and subsequently convert the money into a Roth IRA. This only works if you don’t have any other IRA assets.
Medicare part B and D premiums are based on taxable income. This is actually a two-edged sword when considering Roth conversions. The amount of money converted counts as taxable income, and can drive up Medicare premiums if certain thresholds are crossed (for example, a married Medicare recipient pays $164.90 per month if their modified adjusted gross income is equal or under $194,000; however, if they earn $1 additional dollar, the monthly premium goes up by $65.90 to $230.80). For a couple making over $750,000 per year, the premium jumps to $560.50 per month. On the other hand, not doing conversions, can create the same problem later in life once RMD’s kick in as the RMD’s can, potentially, drive up Medicare premiums as they increase an individual’s taxable income.
What we don’t know…
Future Tax Rates—While we don’t know what they will be, it is unlikely that they will be lower—particularly for high earners. My opinion is that rates will be significantly higher at all income levels as we will need to service our massive debt ($32 Trillion), and the unfunded liabilities of Social Security and Medicare (estimated at $22.7 Trillion for Social Security and $40.5 Trillion for Medicare https://www.aei.org/articles/federal-unfunded-liabilities-are-growing-more-rapidly-than-public-debt/).
Future Taxes—Not only is it possible that tax rates will be higher in the future, but it is also possible that we will have new and/or different taxes than we currently pay. Some of the possibilities that have already been proposed include:
- A wealth tax—this is a tax based on one’s net worth rather than one’s earnings and capital gains. Ironically, this would make Roth conversions even more attractive as they have the effect of lowering one’s wealth while increasing purchasing power relative to traditional IRA assets.
- A national sales tax (or value added tax)—a spending, rather than income, based tax.
- Elimination of step-up in basis—under current law, at death, assets receive a “step-up” to current market value at the date of death. Thus, if I pay $100,000 for my home that is now worth $500,000, but leave it to my kids when I die, they only owe taxes if they sell it for more than the $500,000 value at the date of my death, rather than owing taxes on the $400,000 gain were they not to receive the “step-up”.
Estate Tax—While we currently have an Estate Tax, it only applies to individuals who die with an Estate valued over $12,920,000. This exemption amount has been as low at $1,000,000 as recently as 2011. Again, the lower the Estate Tax exemption amount is, the more valuable Roth IRA assets become relative to a traditional IRA.
