CONGRESS IS BACK at it, aiming to change the tax laws again. Just since 2017, there’s been the Tax Cuts and Jobs Act (TCJA), the SECURE Act and the CARES Act, each of which contained tax provisions, some very significant. As I type this, Congress and the White House are horse-trading on another round of changes.
Because new legislation is still being negotiated, I think it’s too soon to change your financial plan. But there’s one strategy that makes sense for a lot of people, and it may make even more sense if certain proposals become law. That strategy is a Roth conversion. If you aren’t familiar with the idea, I’ve written about it in an earlier article.
The primary benefit of Roth conversions is to take advantage of tax rate “arbitrage.” For example, if you could convert a traditional, pretax IRA to a Roth IRA today and pay a tax of just 24%, you should happily do so if you expect your tax rate to be much higher—say 32% or 35%—down the road.
As I noted in my earlier article, though, it can be tricky to guess your future tax rate. First, you need to estimate your future income. Then you need to guess what Congress will do with tax rates. As we’ve seen in recent years, political winds can shift back and forth frequently, making this a difficult guessing game.
Because of that frustrating reality, I’m not a fan of forecasting. Still, there are two reasons to believe tax rates will indeed be higher in the future:
For those reasons, Roth conversions look appealing right now. If you happen to be retired or have a low income this year for other reasons, this could be an ideal time to complete a conversion, while rates remain at current levels. To be sure, there’s always the possibility that Congress could make any tax increases retroactive to Jan. 1, 2021. But the further we progress into the year, the less likely that seems.
Tax rate arbitrage is the most-commonly cited reason for doing a Roth conversion. Still on the fence? Here are four additional benefits that often get overlooked.
1. Medicare premiums. For most people, Medicare premiums are very reasonable. But the premiums do vary based on income. Specifically, the costs for Part B and Part D both scale up as your income increases. For example, a single individual with income under $88,000 would pay just $1,782 per year for Part B coverage. But with income between $165,000 and $500,000, the cost for Part B more than triples, to $5,702 a year. Part D would also increase, by almost $1,000.
These are called Income Related Monthly Adjustment Amount (IRMAA) surcharges, and they’re effectively another tax. If you can reduce your income in retirement, you can reduce these surcharges. How can you trim income? Roth conversions are particularly effective. Remember, every dollar that comes out of a traditional, pretax IRA is taxable. When required minimum distributions begin at age 72, the size of your pretax IRA will impact the level of your income. But if you convert some of your pretax IRA to a Roth, these taxable distributions will be smaller. If you can shrink your pretax IRA enough, you can bump down those costly IRMAA surcharges—a benefit that can last throughout retirement.
2. Estate tax. Today, the federal estate tax exclusion—the amount you can leave heirs without paying any estate tax—is nearly $12 million per person, or more than $23 million for a married couple. For that reason, it isn’t an issue for most people. But starting in 2026, those limits could get cut in half, to about $6 million and $12 million, if the 2017 tax law is allowed to sunset. These might still seem like big numbers, but there are some wrinkles to keep in mind.
The first is that the estate tax is a political football. That exclusion number has changed many times in the past, it’s likely to continue changing—and, indeed, it’s on the table for discussion right now. In addition, many states impose their own estate tax, often with far lower exclusions. In Massachusetts, for example, the estate tax kicks in at just $1 million of assets. Don’t let that headline $23 million figure lull you into complacency. The estate tax should always be on your radar.
How can Roth conversions help with the estate tax? Suppose you have $15 million in assets, including $3 million in pretax IRAs. If you were to die in 10 years, after the exclusion had reverted to the $12 million level for a married couple, $3 million of your estate would be subject to tax. Now, suppose you complete a Roth conversion this year. If you converted your entire $3 million IRA, you’d pay about $1 million in federal taxes, plus potentially state income taxes. After paying that tax, your estate would now be $1 million smaller—$14 million instead of $15 million. The result: Because the federal estate tax rate is a flat 40%, the bill would be about $400,000 smaller.
This wouldn’t shortchange your heirs in any way. You’d just be paying a tax now that they would have paid later. In fact, this strategy could actually help your heirs, as described next.
3. Taxes on inherited IRAs. Another recent tax law change was the elimination of the so-called stretch IRA. In the past, when children inherited an IRA, they had decades over which to withdraw the funds. The ability to stretch those distributions out over many years meant that the tax impact each year was modest. But under the new rules, heirs must empty the entire account within the first 10 years after the account owner dies. The result is a potentially large amount of additional taxable income for children inheriting IRAs.
But if, instead, you completed a Roth conversion during your lifetime, you’d effectively be paying taxes on your children’s behalf and potentially at much lower rates. Why would the rate be lower? If you think about the normal cycle of life, parents tend to die when their children are in their peak earning years. If you complete a Roth conversion when you’re retired and have a relatively low income, you’ll likely save your children from paying higher rates down the road.
Will this benefit your family? It depends on the size of your IRA, how many children you have, their ages and their careers. But in certain circumstances, it could make an enormous difference.
4. Peace of mind. I often say that there are two answers to every financial question. The first is what the math says. The second is how you feel about it. When it comes to Roth conversions, it’s definitely important to work through the numbers. If Congress agrees on rate increases this year, that’ll tip the scales further in favor of conversions. But ultimately, we’re still in the land of predictions.
You can never be sure how things will work out. Tax rates, longevity and market growth all remain unknowns. But that uncertainty ends up being a point in favor of Roth conversions. Once you’ve paid the tax to move funds into a Roth IRA, you can be virtually certain the money will never be taxed again. That’ll provide you with a benefit that’s unquantifiable but highly valuable: peace of mind.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, he advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman and check out his earlier articles.
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With regard to the TVM question below, as long as the tax rate stays the same it is a wash. Consider a $100K investment in a trad IRA making 10%, and a 24% tax rate. If you convert that $100k to a Roth, you net $76K. Invested at 10% for a year and you have 1.1 * $76,000 = $83,600. If you left the $100 in the trad IRA it would grow to $110K after 1 year. If you withdrew the $110K, paying 24 % to taxes, you would net $83,600. So any TVM considerations presumes you know future tax rates. It comes down to the same conclusion – Roths are better if future tax rates exceed current rates. Secondary considerations, such as Adam discusses in the article, help tip the argument in favor of conversion amidst tax rate uncertainty.
#4 Peace of Mind. Having converted the lion’s share of my IRA to a Roth the satisfaction of that account growing without having to partner with Uncle Sam on the gains. Even if rates stay the same a growing tax-free balance “feels” better than a growing tax-deferred balance.
Totally agree. Now if we could just find a way to prevent Congress from ever taxing withdrawals from Roth IRA accounts. I guess I am cynical but I do not trust them. “Yes we know you already paid taxes on that money, but we need the revenue more than you do for our critically important investments in America…” Said as they divert huge sums to their districts as pork so they can get reelected.
Hmmm…..the humble dollar? Saturday, working in retirement, delaying Social Security, cutting expenses. Sunday, retirees with incomes between $163K and $500K, how to avoid estate taxes if you have $15 million. Something for everyone!
I had a similar reaction.
Also, personally, I’m happy to pay a proportional part of my income through taxes to support the health of the society I live in.
I guess I should add that my IRA is a Roth, and I’m also taking advantage of Roth contributions in my 401K.
My comment was mainly in reaction to the larger balances mentioned in the article, along with what I interpreted as some anti-tax views in the comments here.
I didn’t know most of this so thank you.
“If you can shrink your pretax IRA enough, you can bump down those costly IRMAA surcharges”
I suppose if enough people make Roth conversions, and IRMAA revenue is less than expected, Congress could increase the IRMAA surcharges.
Have you ever heard of the time value of money? What are the actual calulations for the reduction in cash outlays for an individual over time adjusted for the time value of money?
The usual suspects and their failed ideology are gonna raise taxes…guaranteed.
Nice article Adam. This is a story that can’t be told enough, because so few understand the nuances. The other item is SS taxation, and reducing income to limit that if possible. I’m looking at our retirement income plan as a multi-variate optimization problem. How do we limit taxes, when do we incur them, do we incur them or leave them to our kids, and am I overcomplicating this? I guess its the price of having assets and choices.
I’ve been mulling the same issues, in particular the impact of AGI on SS And Medicare premiums and related payments. We took an uncertain step by moving 401K contributions to Roth (our companies offer both Trad and Roth). It may be a bit premature, but our savings so far are likely to take us up to our current income bracket in retirement, barring the unforeseen. That’s already locking in some hefty additional costs for the items above unless we can do Roth conversions. I understand Roth IRAs to be better for passing on inheritances under current law.