Roth conversion makes sense in today’s low tax rates

For a long time, converting your traditional IRA to a Roth version was a fairly low-risk proposition. If you changed your mind later, you could always reverse course. That ended with the tax bill signed by former President Trump in December 2017.

The legislation eliminated the option to “recharacterize” a Roth conversion to a traditional, SEP, or SIMPLE IRA beginning in tax year 2018. It did the same for Roth IRA funds transferred from 401(k) and 403(b) accounts. There was a short window until October 15, 2018, in which you could still reverse a 2017 Roth conversion. Needless to say, that deadline has passed.

Basic Takeaways

  • If you converted to a Roth in 2017, you missed out on lower tax rates. It is too late to reverse this conversion.
  • However, if you have a traditional IRA or 401(k), today’s historically low rates should make you consider converting to a Roth.
  • The new rates apply until 2025.

On the other hand, we have historically low tax rates right now. So converting a traditional IRA or 401(k) to a Roth and keeping it there makes more sense than ever. Unless it is, count on tax rates to be even lower than the 10% to 37% rates that are locked in now through 2025.,,

Effect of changes in tax rates

With a traditional IRA, savers contribute on a pre-tax basis and pay ordinary income tax rates when they withdraw the funds in retirement. A Roth IRA offers similar benefits but in reverse. You pay the usual taxes now to make tax-free withdrawals down the road.

Switching to a Roth makes the most sense if paying Uncle Sam results in a lower tax liability overall. Take, for example, a married couple who converted their $200,000 traditional IRA account — made up entirely of pre-tax money — to a Roth in 2017 before the Tax Cuts and Jobs Act. Let’s further assume they had $100,000 of other taxable income.

Under the previous tax law, their $200,000 bill would have been subject to a 33% tax rate for 2017. (Any previously tax-free money you reclassify as a Roth is added to your adjusted gross income for tax purposes.) The conversion alone would result in a $66,000 payment to Uncle Sam. Meanwhile, $200,000 of income is only taxed at 24% in 2021 for those married filing jointly.

The Tax Cuts and Jobs Act (TCJA) lowered marginal tax rates for individuals. The updated tax rates from the TCJA are set to expire in 2025. Here’s a look at the tax rates for 2022.

Tax rates 2022
Price Married Joint Return One person Head of household Married Separated Return
10% $20,550 or less $10,275 or less $14,650 or less $10,275 or less
12% Over $20,550 Over $10,275 Over $14,650 Over $10,275
22% Over $83,550 Over $41,775 Over $55,900 Over $41,775
24% Over $178,150 Over $89,075 Over $89,050 Over $89,075
32% Over $340,100 Over $170,050 Over $170,050 Over $170,050
35% Over $431,900 Over $215,950 Over $215,950 Over $215,950
37% Over $647,850 Over $539,900 Over $539,900 Over $323,925

Relaxing this conversion before October 15th may have been a wise move. If the couple were to repeat the Roth conversion in 2018 at today’s lower interest rates, they could have saved quite a bit of money, assuming their account balance remains unchanged. By the same token, a couple in the same bracket in 2021 could convert a traditional IRA or 401(k) and pay for the conversion at today’s lower rates.

To wait or not to wait

Keep in mind that the personal income tax cuts passed into law are expected to take effect through 2025. Congress can extend the cuts or enact a very different tax law. It is impossible to predict.

One thing is certain, the current tax rates are relatively low. And, assuming you keep contributing money and your money keeps earning money, your account will grow. Each year, it will be harder to pay the income tax bill that comes with a Roth conversion.

But the biggest attraction of a Roth is that you never owe money on the account again. When you start taking the money out, probably after you retire, you won’t owe any more taxes on the capital or gains as long as you take appropriate distributions.

This differs from a traditional IRA or 401(k), in which you pay income taxes on both the principal and earnings as you make withdrawals.

Also, keep in mind that you don’t have to convert all of your money at once. You can limit your tax hit by spreading the process over several years, converting equally to stay in your current bracket.

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