Roth IRAs and Roth conversions have become a hot topic over the last several years in financial media. One of the reasons is simply the amount of people these strategies now apply to. With the ‘Baby Boomer’ demographic reaching retirement age, more than 25% of the United States population are in or approaching retirement. Also, since covid-19, we’ve seen an uptick in those retiring before traditional retirement ages. For example, the Federal Reserve Bank of St. Louis estimated that between 2020 - 2021 an additional 2.4 million people retired due to the pandemic that otherwise would have continued to work.
When it comes to retirees, there are four main reasons we look at Roth Conversions.
1. Tax brackets are set to return to pre-2018 levels in 2026.
The table below shows what is currently in tax law today. Taxpayers will enjoy another two years, after 2023, of favorable tax brackets. Unless Congress and the President sign a new tax law into effect before 2026, many will see their taxes on ordinary income rise in 2026. We see many retirees want to take advantage of the 12% and 22% brackets while they still exist.
2. Roth Conversions offer flexibility in distributions for the future.
For those retirees in their early-to-mid 60s with the majority of their retirement nest-egg in Traditional IRAs, they enjoy a lot of flexibility in how much and when they take those ‘always-taxable’ distributions. However, once those retirees hit their required beginning date (the date in which required distributions begin), they lose that flexibility. Recent changes by Congress have pushed the RMD (Required Minimum Distribution) age from 70.5 to 72, and then from 72 to 73, and for those born after 1960, age 75. We have seen where clients were happily taking out $25,000 - $35,000 a year from their IRAs to supplement their lifestyle after Social Security benefits but now that their RMDs have begun need to take out $90,000+ from their IRAs. Roth Conversions allow taxpayers to capture some of these lower tax brackets and shield those Roth dollars from future required distributions. Note that under current tax law, Roth IRAs do not have required distributions (unless they are inherited).
3. Roth Conversions shield the household from higher taxes if one spouse were to predecease the other.
It’s not a fun topic, but when you work with retirees you unfortunately have to navigate when a loved one passes before their time. The third advantage of Roth Conversions is using the Married Filing Jointly tax brackets while they are available. Let’s take that same couple I mentioned above. Assuming they have both reached their RMD age, whether they are both living, or one spouse passes away, the Required Distribution amount does not change. Let’s assume the couple both make $24,000 a year in Social Security benefits ($48,000 total) and have a required distribution of $90,000 from their IRAs, in 2023 after the standard deduction they will pay about $12,500 in Federal Tax when filing Married Filing Jointly. If we take that same couple but one of them predeceases the other, the surviving spouse will lose the deceased spouses $24,000 in Social Security benefits but still have the $90,000 required distribution. So, the widow now has $24,000 less in income due to the loved one passing but now has a Federal Tax bill of over $16,000. That’s $3,500 more taxes with less income! And if we assume the surviving spouse needs the additional $24,000 of income to maintain their lifestyle, those additional $24,000 of IRA distributions would take their tax bill to almost $22,000! That’s almost $10,000 more in Federal taxes for the same amount of income, only because the surviving spouse is now filing Single instead of Married Filing Jointly.
4. Roth Conversions protect your heirs from taxes.
When it comes to leaving a legacy, we’ve heard a lot of opinions from clients. Some take the approach that they don’t want to leave anything. Others want to leave something but take the approach of “whatever is left is fine”. But some clients want to be very specific, for example, “We want to make sure each of our four children receive $100,000 and they receive it tax-free. The rest will go to charity”. Roth Conversions can be an excellent way to pass down wealth to the next generation. When your heirs take distributions from an inherited Roth IRA, they receive it tax-free. Whereas an inherited Traditional IRA your heirs will pay tax just like you would.
If you are interested in understanding how Roth Conversions may help your retirement and accomplishing specific goals, please feel free to reach out to us at (219) 465-6924.
Mark Rosinski, CFP®, CPA