Roth Conversions: More Important Than Ever Before
A Roth Conversion is when you distribute money out of a regular IRA and “convert” it into a Roth IRA. Because you are taking a distribution from your IRA, this creates taxable income. If the funds are then left in the Roth IRA for five years or more (and you are over 59½), earnings in a Roth IRA can be withdrawn tax-free. The idea is that you pay taxes today and never get taxed on those funds again. Prior to 2018, you could change your mind and recharacterize (or undo) a Roth Conversion.
The Tax Cuts and Jobs Act of 2017 scrambled a LOT of tax and financial planning. Besides some seismic shifts in corporate and personal income taxes, it also made a number of changes to the details of personal income taxation. One of these was to eliminate the ability to recharacterize amounts converted into a Roth IRA. Said another way: once done, a Roth Conversion is now permanent.
Roth conversions have been a useful tool for managing taxable income, and the ability to “undo” a conversion was very important. Still, I think that Roth Conversions may now be more important than ever, even if you can’t change your mind later.
One of the goals of tax planning is to avoid creating any additional tax. If tax rates in the future are the same as today, there’s no mathematical difference between paying the tax today (Roth conversion) versus keeping the money in an IRA and paying taxes on the withdrawal later. But if tax rates will be higher in the future, paying tax today might actually be better than waiting.
And this is what sets up the planning opportunity: The currently low tax rates expire in 2026. That means that tax rates today are quite likely lower than they will be in the future for the same income.
There are basically five reasons why you would want to convert money to a Roth IRA:
Take advantage of large deductions. If you have a large net operating loss or charitable deduction to offset the taxable income created by the conversion, you can essentially create a “free” conversion. For example, if you start a business and your net income after writing off losses is $30,000, you could convert $30,000 from an IRA to a Roth to zero out your taxable income. You could even convert more and still keep your taxable income very low.
Roth IRAs don’t have minimum distributions. Traditional IRAs require you to start taking money out at age 70½. Roth IRAs don’t have this requirement, so you can keep the funds inside the (tax free) IRA longer.
Tax brackets are more favorable for married couples. This means that income withdrawn from an IRA (including conversions) before the first spouse’s death are done at a lower tax rate than when the survivor is single. For example, if your taxable income today (including minimum distributions and Social Security) is $160,000, that would put a married couple in the 22 percent tax bracket. A single filer (widow) would be taxed at 32 percent today on the same income.
Tax rates will probably be higher in 2026. Using the last example, that 22 percent tax bracket today would be 28 percent for married couples in 2026, so converting today moves the money to a tax-free account at a lower cost.
Estate taxes. If you have a very large IRA, it gets complicated. It’s probably better convert to a Roth IRA and pay lower income taxes before 2026. This leaves an income tax-free Roth IRA to your heirs instead of the taxable traditional IRA. That’s because the traditional IRA will owe estate taxes then income taxes on whatever is left over, especially if you live past 2025.
Remember that you can’t undo a Roth conversion anymore, so you should work closely with your tax planner to make sure you don’t overdo it. You may also want to wait until later in the year so that you have a better idea of you income for the year and how your conversion will affect you.
Today’s temporarily low tax rates offer an excellent opportunity to do a little tax arbitrage.
This column is prepared by Rick Brooks, CFA®, CFP®. Rick is Director/Investment Management with Blankinship & Foster, LLC, a wealth advisory firm specializing in comprehensive financial planning and investment management. Brooks can be reached at (858) 755-5166, or by email at rbrooks@bfadvisors.com. Brooks and his family live in Mission Hills.
