Should You Do a Roth Conversion?

Deciding when you would like to pay taxes on your retirement assets is often tricky and depends on multiple factors such as current income and financial situation, future financial expectations, and sometimes personal preference or personality type. The specter of taxes always looms large and choosing when to face it can be a tough call. However, there are four reasons why I think that now may be the time to consider shifting your taxable assets to tax free assets.

First, the passage of the SECURE Act, the biggest retirement legislation to pass in a decade, has made some changes to the retirement landscape that make a Roth conversion more attractive. One such reason is that the act has effectively killed the so called “Stretch IRA”. When a beneficiary inherits an IRA, the previous law allowed the beneficiary to keep the assets invested inside of an IRA and take an annual withdrawal based on a Required Minimum Distribution (RMD) calculation as one of the withdrawal options. This would allow the beneficiary to "stretch" the IRA over their lifetime and should ultimately allow them to withdraw more from the inherited funds. Taxes would of course still be owed on the withdrawals, assuming it's a tax deferred account such as a Traditional IRA. Under the new law, in most cases, the maximum number of years that you can stretch an inherited IRA is 10 years. This makes a tax deferred account such as a Traditional IRA an even less desirable estate planning vehicle, as you would be leaving heirs a potential tax burden. The withdrawals from an inherited IRA are taxed as income in the year the withdrawal occurs. In other words, if the inherited IRA owner had to withdraw $100,000 from the inherited IRA this year, it would increase their taxable income by $100,000 and could cause their normal income to be taxed at a higher amount. This may make a Roth IRA a better and more tax efficient asset to pass to heirs. The beneficiaries would still need to withdraw the funds within 10 years, only this time the funds would be considered tax free in most instances.

Second, speaking of RMDs, Roth IRAs do not require you to take Required Minimum Distributions in retirement. The SECURE Act has raised the age to start taking your RMDs to age 73 on tax deferred accounts. In the year 2033, the age will increase to 75. However, there is no such requirement with Roth IRAs. This could allow the funds to grow tax free for life without ever being diminished by mandatory withdrawals, ultimately allowing you to leave more generally tax-free assets to heirs. This would also keep you from taking a taxable distribution from your retirement accounts and potentially increasing your taxable income.

Third, many retirement benefits are income based. Medicare supplement premiums and taxes on your Social Security benefits are both based on income. In 2023, your Medicare Part B premiums could cost you anywhere between $164.90 per month up to $560.50 per month depending on your 2021 income*. Also, your Social Security benefit could be taxed depending upon your income. For a married couple filing jointly, if you claim over $44,000 in income, 85% of your Social Security benefit is taxed as income. As a kicker, 50% of your Social Security benefit counts toward the income calculation**. So if that same couple gets a total of $50,000 in Social Security benefits, $25,000 of that counts toward the income calculation. They would only need to have another $19,000 in income from another source to put them over that $44,000 threshold. Any withdrawals from Roth IRAs are generally tax free and do not count toward that income calculation. Whereas any withdrawals from tax deferred accounts, including RMDs, will count as taxable income and could ultimately put you in a higher income tax threshold.

Fourth, the changes to the individual tax rates that the Tax Cuts and Jobs Act ushered in will likely end after the year 2025***. This means that for most people, they will see a lower tax bill for the next handful of years. This may allow the perfect opportunity to look at a Roth conversion since we know taxes will be lower for at least the next few years. When performing a Roth conversion, the amount that you convert from a tax deferred account into a Roth account is taxable as income in the year the conversion takes place. In other words, if you convert $50,000 this year from your Traditional IRA to a Roth IRA, that $50,000 that you convert would count as taxable income for the year. This makes it imperative to consider your income situation for the year to consider how much you should convert in that year, or if you should convert any at all. Upon the conversion, you should be able to have the financial institution withhold taxes for you, or you can be responsible to pay the taxes out of pocket come tax time if you choose to not have them withhold taxes. If you believe taxes will increase in the future, wouldn’t it make sense to go ahead and pay taxes on these assets now as opposed to waiting until taxes are potentially higher, even perhaps much higher?

Given the current environment we are in, now may be the time to consider some tax diversification in your financial plan. It’s important to consult with your financial and/or tax professional to discuss if converting some of your taxable assets into tax free assets would make sense for your overall financial and estate planning.