Roth conversion makes sense given today’s low tax rates

For a long time, converting your traditional IRA to a Roth version was a fairly low-risk endeavor. If you change your mind later, you can always reverse course. That ended with former President Trump’s tax bill signed into law in December 2017.

Legislation eliminated the option to “recharacterize” a Roth conversion back to a traditional, SEP, or SIMPLE IRA beginning with tax year 2018. The same applies to Roth IRA funds classified by 401(k) and 403(b ) were transferred. accounts. There was a brief window, until October 15, 2018, during which you could still undo a 2017 Roth conversion. Needless to say, the deadline has passed.

The central theses

  • If you switched to Roth in 2017, you were missing out on lower tax rates. It’s too late to undo this conversion.
  • However, if you have a traditional IRA or 401(k), today’s historically low interest rates should persuade you to convert to a Roth.
  • The new tariffs apply until 2025.
  • There is no need to convert all funds at once.
  • With the appropriate authorization, an account holder can receive Roth contributions and income tax-free.

On the positive side, we currently have historically low tax rates. As such, it makes more sense than ever to convert a traditional IRA or 401(k) to a Roth and leave it there. Unless they do, expect tax rates to fall even further below the 10% to 37% now set through 2025.

Impact of Tax Rate Changes

With a traditional IRA, savers deposit on a pre-tax basis and pay ordinary income tax rates when they withdraw the money in retirement. A Roth IRA offers similar benefits, but in reverse. You pay normal taxes now to be able to make tax-free qualifying withdrawals later.

Switching to a Roth makes the most sense if paying Uncle Sam now results in less tax liability overall. Take, for example, a couple who converted their traditional $200,000 IRA account — consisting entirely of pre-tax money — into a Roth in 2017 before the Tax Cuts and Jobs Act. Let’s further assume you have $100,000 in other taxable income.

Under the previous tax law, her $200,000 account should have been subject to a 33% income tax rate for 2017. (Any previously untaxed money that you reclassify as Roth will be added to your Adjusted Gross Income for tax purposes.) The conversion alone would result in a $66,000 payment to Uncle Sam. Meanwhile, $200,000 of income is taxable at 32% in 2022 and 2023.

The Tax Cuts and Jobs Act (TCJA) lowered marginal tax rates for individuals. The updated TCJA tax rates expire in 2025. Here’s a look at the tax rates for 2023.

Tax rates 2023
rate Married joint return single person head of household Married separate return
10% $22,000 or less $11,000 or less $15,700 or less $11,000 or less
12% $22,000 to $89,450 $11,000 to $44,725 $15,700 to $59,850 $11,000 to $44,725
22% $89,450 to $190,750 $44,725 to $95,375 $59,850 to $95,350 $44,725 to $95,375
24% $190,750 to $364,200 $95,375 to $182,100 $95,350 to $182,100 $95,375 to $182,100
32% $364,200 to $462,500 $182,100 to $231,250 $182,100 to $231,250 $182,100 to $231,250
35% $462,500 to $693,750 $231,250-$578,125 $231,250 to $578,100 $231,250-$346,875
37% $693,750 and up $578,125 and up $578,100 and up $346,875 and up

Reversing that switch before October 15 might have been a smart move. If the couple had done the Roth conversion again in 2018 at today’s lower rates, they could have saved quite a bit of money assuming their account balance stayed the same. For the same reason, a couple in the same group could convert a traditional IRA or 401(k) in 2022 and pay for the conversion at today’s lower rates.

To wait or not to wait

Keep in mind that individual income tax cuts enacted by law are expected to be in effect through 2025. Congress can extend the cuts or enact an entirely different tax law. It’s impossible to predict.

What is certain is that today’s tax rates are relatively low. And assuming you keep depositing money and your money keeps making money, your account will grow. Every year it gets harder to pay the income tax bill associated with a Roth remodel.

But the biggest appeal of a Roth is that you should never owe money on the account ever again. When you start withdrawing the money, probably after you retire, you will not owe any further tax on the capital or income as long as you receive qualifying distributions.

This differs from a traditional IRA, or 401(k), where you pay income taxes on withdrawals on both the principal and income.

Also remember that you don’t have to exchange all your funds at once. You can limit your tax burden by spreading the process over several years and converting just enough to stay in your current class.

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