SHOULD I CONVERT TO A ROTH IRA?
Sounds like a simple yes or no question, doesn’t it? If only that were true.
The wonderful thing about Roth IRA accounts is they grow and compound into income tax-free dollars.
The problem is you must pay taxes on the funds before they can be contributed to a Roth IRA account. That means money you contribute directly to a Roth IRA or a Roth 401(k) account does not provide a tax deduction in the year the contribution is made, and tax-deferred IRA assets you convert to a Roth IRA are taxable in the year of the conversion.
Calculating whether you end up with more tax-free money to spend later versus the money you save on income taxes today is more complex than a simple yes or no.
There are, however, some important points you should understand when choosing whether a Roth IRA conversion or Roth IRA contribution makes sense for you.
YOUR CURRENT & FUTURE MARGINAL INCOME TAX RATE
Not to be confused with your effective income tax rate, your marginal income tax rate is how much your last dollar of income is taxed. Current US income tax rates (2023) are 0%, 10%, 12%, 22%, 24%, 32%, 35%, and 37%.
If your future expected marginal income tax rate is lower than your current marginal income tax rate, then you should be wary of making conversions to a Roth IRA -- it might be a better option to wait until your marginal income tax rate is lower to begin making conversions or taking taxable withdrawals.
This might be someone in their peak earning years who will pay a lower rate once they retire. Here, it would make sense to get the current income tax benefit of a deductible Traditional IRA or 401(k) contribution and revisit the conversion decision once you reach retirement.
Conversely, if your current marginal income tax rate is lower than what your future marginal income tax rate will be, Roth IRA contributions and Roth IRA conversions could make sense.
Maybe you’re a recent retiree with large tax-deferred IRA assets and additional pension income that can be supplemented with after-tax savings. Your current marginal tax rate could be very low, but in the future, you will be forced to supplement your income with tax-deferred assets. To lower the total lifetime taxes you must pay, executing Roth IRA conversions now might be the answer. It will provide a tax-free source of income later which gives you the opportunity to manage your marginal income tax brackets in the future.
Compound interest has been called the eighth wonder of the world. It is amazing how the last few years of long-term savings exponentially increase the dollar value of an account. A Roth IRA funded with just $6,000 today and compounding at 8% projects to reach a value over $41,000 in 25 years -- and over $60,000 in 30 years.
The younger you are, the more attractive Roth IRA and Roth 401(K) contributions and Roth IRA conversions become. If you have a 30-year time horizon it is hard to say no to 10X your money income tax-free in retirement.
DO YOU RECEIVE SOCIAL SECURITY BENEFITS?
Okay, you waited until you retired, and your income tax bracket has dropped. You still might not get an all clear on Roth IRA conversions. The amount of your social security benefits subject to income taxes vary by your other sources of income. Currently, (and for a long time now, because these amounts are not adjusted for inflation) 50% of your social security benefits are included in taxable income for joint filers with combined income between $32,000 and $44,000. Any combined income greater than $44,000 subjects 85% of your social security benefits to taxation. For single filers the 50% limit on combined income is $25,000 to $34,000 and then jumps to 85% above $34,000.
Because of these cliff limits, social security recipients could find themselves in the odd position of having a higher effective rate than marginal rate if they choose to convert money into Roth IRAs. This seldom makes good economic sense.
QUALIFYING FOR AFFORDABLE CARE ACT (ACA) PREMIUM TAX CREDITS (PTCs)
For retirees who are too young to qualify for Medicare and lack health insurance coverage from their former employer, managing your income to qualify for ACA health insurance subsidies is very important.
We have worked with a number of newly retired clients to fund their early retirement years with after-tax savings and pension income, allowing them to receive substantial subsidies for their health insurance premiums called Premium Tax Credits (PTCs). Sometimes it’s necessary to convert some tax-deferred IRA funds into Roth IRA accounts to have enough taxable income to qualify for PTCs, yet not so much that they miss out on this valuable subsidy. On the other hand, Roth IRA conversions could be detrimental to receiving PTCs. Plan carefully here, PTCs can be worth thousands of dollars each year.
CONTROLLING REQUIRED MINIMUM DISTRIBUTIONS (RMDs)
Large tax-deferred IRA balances (Rollover, SEP, SIMPLE, Traditional, etc.) can wreck your income tax plan. By projecting the required minimum distribution (RMD) requirements you could find that although you have retired and are in a manageable marginal income tax bracket today, the RMD rules could force you into much higher marginal tax brackets in the future. Your goal in managing taxes shouldn’t be to pay the lowest amount of taxes possible today -- but pay the lowest total dollars in income taxes over your lifetime.
By making strategic Roth IRA conversions early in retirement, you might be able to keep more of your IRA dollars tomorrow. Maybe you can maximize the 24% marginal rate now even if you could be in the 12% bracket, rather than paying taxes on your RMDs at 32% in the future.
DON’T FORGET IRMAA MEDICARE PREMIUM SURCHARGES
Many taxpayers are surprised to find out that the higher their income in the last year, the higher their Medicare Part B and D premiums are.
For those who receive Part B and Part D Medicare benefits, there are tiers related to your income that determine your monthly Medicare premiums. Medicare uses the Modified Adjusted Gross Income (MAGI) reported on your 1040 from the previous year to set your premiums for the following year.
For 2023, single filers with MAGI of $97,000 or less and joint filers with MAGI of $194,000 or less in 2021 pay the basic Medicare premium of $164.90 per month. If you exceeded those income levels in 2021 your monthly premium will be higher. You need to incorporate any anticipated Medicare premium increases into your calculations to determine any net savings you might expect from utilizing a Roth IRA conversion strategy.
CONSIDER YOUR HEIRS
Sadly, the SECURE Act makes inheriting tax-deferred IRA accounts fraught with problems. If leaving money to your heirs is a priority for you, converting tax-deferred IRA funds to Roth IRA funds might make sense. Your heirs will very likely inherit any IRA funds during their peak earnings years and will have to withdraw the funds over a 10-year period beginning in the year following your year of death. The net amount they receive will probably be greatly reduced by the income tax liability that comes with inheriting tax-deferred IRA funds.
For information on steps you can take to minimize the income tax leakage see our post “Solutions to the SECURE Act Stretch IRA Problem”. If leaving money to your heirs is important to you, that will make Roth IRA conversions more attractive to you.
In the end, choosing whether to contribute to a Roth IRA or a tax-deferred IRA and choosing when and how much to convert to a Roth IRAs is a complicated decision. But the income tax savings can be significant. To be sure you are making good choices, you should seek out competent financial professionals.