The Time Is Right For Roth IRA Conversions

When I was younger, I never considered the long-term tax implications of investing in an individual retirement account (IRA). My thinking was simply, “If I can shelter some income from taxes, I am going to do so.”

It was conventional wisdom that when you retire, you would probably be in a lower tax bracket. Thus, IRA contributions could grow tax-free for many years before I finally began to make withdrawals, paying lower taxes on them in my retirement years.

I began to maximize my IRA contributions as soon as I started working. Over the years I built up a sizable nest egg in my various IRAs before the tax implications began to dawn on me.

A Growing Problem

As my IRA accounts grew, it became clearer to me that my retirement income would likely push me into a higher tax bracket. Those deductions I took when I was in the 15% federal tax bracket (and in a state with no state income tax) could get taxed at double that rate if my income was significantly higher in retirement. It could also be subject to state income taxes.

If your traditional IRA has grown substantially, you may fall into this category. Why? Because of required minimum distributions (RMDs). The IRS forces you to begin taking money from your conventional IRA when you turn 70.5. That distribution is going to amount to at least $40,000 per million dollars of IRA value.

Tax Reform to the Rescue

You may be thinking “I only wish I had this problem.” But if you do find yourself in this situation, the Tax Cuts and Jobs Act (TCJA) of 2017 may offer a way to reduce your taxes in retirement.

Because the TCJA cut tax rates to their lowest levels in years, you can convert your conventional IRA to a Roth IRA and pay lower taxes on the conversion than you would have a couple of years ago.

A married couple with $250,000 of taxable income (after adjustments) would have previously found themselves in the 33% tax bracket. Today, they are in the 24% bracket. Converting a $100,000 conventional IRA to a Roth IRA would be $9,000 cheaper for this couple than it was prior to the TCJA.

Further, passage of the TCJA has coincided with a huge spike in the federal budget deficit. Thus, it seems likely that Congress and a future administration will find themselves needing to raise taxes. At the current rate of deficit growth, we could eventually wind up with higher tax rates than we had before the TCJA. That’s not what you want to see in retirement with a conventional IRA.

The huge advantage of a Roth IRA is that the distributions aren’t subject to federal income taxes or most state taxes. So, if you think your tax rate will be higher in retirement, it makes more sense to shift as much money as possible into a Roth IRA. This has never been more true than now, with tax rates lower than they are likely to be again for many years.

Check the Numbers

Of course the big caveat is that the conversion is treated as a taxable distribution from your traditional IRA. So a conversion will trigger a bigger federal income tax bill for this year. State income taxes may also apply. You have to be able to pay those tax bills in order to do the conversion.

If your income is predictable, the best path forward would be to estimate your tax bill with and without the conversion. If you have an accountant, they can easily check this for you.

Personally, I am going to convert one of my traditional IRA accounts this year, and perhaps another next year. That gives me a manageable tax bill, which wouldn’t be the case if I converted everything in one year.