EVERY YEAR, the NCAA basketball season concludes with the March Madness playoffs. Many Americans engage in bracketology—trying to figure out which teams will get knocked out in each round and which will advance. Warren Buffett even offers an annual bracket-picking challenge, where Berkshire employees can win $1 million a year for life.
This year, however, Americans with substantial retirement accounts might also want to try another form of bracketology: studying the 2017 tax law—and asking whether it offers a unique opportunity to convert hefty amounts of traditional IRA money to a Roth IRA.
For most middle-income Americans, the 2017 tax law lowered their marginal income tax rates by three or four percentage points. The rate cuts are great, though there are some offsetting lost tax benefits, such as the new limit on state and local tax deductions and the loss of personal exemptions.
How does all this affect Roth conversions? There are two important considerations. First, suppose you’ve accumulated a sizeable sum in all your 401(k)s, IRAs and similar tax-deferred accounts, including those of your spouse. Once each of you turn age 70½, you’ll be required to draw down those accounts and pay income taxes on the distributions.
For instance, if you have a combined $1.5 million in retirement accounts at age 75, the required minimum distribution (RMD) would be $65,502. Add that distribution to any pension, Social Security and other income, and your total income could rise above $100,000 and move you into higher tax brackets.
That brings us to the second consideration: 2017’s tax cuts are scheduled to end in 2025—and they could disappear after 2020’s election. That means there’s a brief but potentially unique opportunity to take advantage of today’s unprecedented low marginal tax rates.
In 2017, under the old law, a couple filing jointly paid tax at a 25% marginal federal rate once their taxable income was above $75,900. That marginal rate rose to 28% for income above $153,100 and 33% above $233,350. By contrast, in 2019, a couple can have taxable income of up to $321,450 and still be in the 24% bracket. While $321,450 is an income level normally associated with the top few percenters, even those of us with more modest incomes can take advantage of today’s extended low tax rates—by undertaking relatively large Roth conversions. Indeed, relative to 2017’s tax rates, the tax savings for a couple would be nine percentage points on Roth conversions that pushed their incomes into the $233,350-to-$321,450 range.
What if you’re a single individual? The tax savings aren’t quite as impressive, but they’re still large. In 2017, the 25% bracket started at $37,950. This year, single individuals can remain in the 24% bracket with taxable income of up to $160,725.
All this raises a crucial question: Before the current favorable tax rates are potentially rescinded, should you seize the opportunity to convert large amounts out of your traditional retirement accounts? This will trigger up to 24% in federal income taxes on the sums involved—but it will get the money into a Roth, where it’ll grow tax-free thereafter. That could be a savvy move if you suspect that the alternative is to pay taxes at an even steeper rate in later years, especially once you start RMDs.
If you do opt for large Roth conversions, make sure you have enough money set aside to cover the resulting tax bill. Ideally, you should try to avoid dipping into your retirement accounts to pay that bill—and you certainly don’t want to be doing so if tapping your traditional retirement accounts triggers tax penalties as well. Those over age 63 should also remember that a large Roth conversion could result in a potential Medicare premium surcharge two years later.
Beyond the tax-free growth, Roth IRAs offer other advantages: You aren’t required to take RMDs from a Roth IRA. If a Roth conversion today results in less taxable income in retirement, you may also end up with lower future Medicare premiums. What about the tax on your Social Security benefit? If your traditional retirement accounts are so large that your withdrawals could push you into a steep tax bracket, you are—alas—probably destined to get taxed on the maximum 85% of your Social Security benefit, even if you undertake substantial Roth conversions today.
What if you don’t spend down your Roth during your lifetime? There could be one final bonus: An income-tax-free Roth IRA is perhaps the best asset your family could hope to inherit.
John Yeigh is an engineer with an MBA in finance. He retired in 2017 after 40 years in the oil industry, where he helped negotiate financial details for multi-billion-dollar international projects. His previous articles were Don’t Concentrate, No Free Ride and Other People’s Stuff.