Originally posted 05/18/2021
A Roth IRA conversion opens the door to a unique financial planning opportunity. Below will look at Roth IRA strategies and what you should consider when implementing one.
Many of us do not enjoy paying taxes. The conventional wisdom is that they are a necessary evil, but after 20 straight years of federal budget deficits you begin to wonder how necessary they are. When it comes to evaluating a conversion from your pre-tax retirement accounts to a post-tax Roth IRA, one might wonder “why would I voluntarily pay tax now when I can defer it until later?”. It’s a good question, and involves a number of moving parts. Roth IRA conversion strategies have exploded in popularity due to the sunset provision built into the 2017 Tax Cuts and Jobs Act.
The Tax Cuts and Jobs Act (TCJA) was passed at the end of 2017 and in order to comply with certain budgetary constraints, the provisions of the bill are only effective from 2018 – 2025 (Fun fact: federal revenue increased after this tax cut). Unless the tax cuts are extended or a new bill is put into place, in 2026 the old brackets will be brought back. As you can see in the screenshot below from taxpolicycenter.org, the TCJA of 2017 did widen some of the income brackets substantially while lowering the rates. Not shown in the screenshot is the expansion of the child tax credit and enhancement of the standard deduction.
These brackets have adjusted a little bit for inflation since 2018.
If we know that the 12% federal bracket will become 15% in 2026, we may want to consider filling up that 12% bracket with Roth IRA conversions. Imagine you are married and you have a taxable income of $60,000, that gives you roughly $17,400 of wiggle room left in the 12% bracket for a Roth IRA conversion. Further, you could argue it is unlikely for many people they will ever pay less than 12% on their IRA dollars so it would be wise to move forward with paying the tax now.
One perk of living in Illinois is that your retirement contributions to Traditional IRAs and 401k plans go in pre-tax at the state level, but when they are drawn out they are not taxed by the state. With the Illinois income tax rate currently at 4.95%, this means you could defer $26,000 into your pre tax 401k and save $1,287 of state income taxes. If you chose to convert those funds the next calendar year to a Roth you would only pay federal tax on the conversion! Imagine you had a marginal federal rate of 22% and 4.95% for Illinois, giving you a combined rate of 26.95%. You defer at 26.95% and convert a year later to a Roth at the same 22% federal bracket you’re currently in.
So should everyone be maxing out their marginal income tax brackets with systematic Roth IRA conversions? Nope, more analysis is needed.
If you are currently on Medicare or will be on Medicare two calendar years from now, you need to be more analytical in your evaluation of a Roth conversion. Medicare will look at your modified adjusted gross income (MAGI) from two years ago to determine if you must pay an adjusted premium for parts B and D. There is an important distinction here, the brackets in the screenshot above are for taxable income, while Medicare considers modified adjusted gross income.
If you are married filing jointly and have a taxable income of $165,000 (upper range of the 22% bracket), then your MAGI is at least $190,100 as the standard deduction is now $25,100. If you were to blindly max out the 22% federal tax bracket with a Roth IRA conversion while not being aware of the Medicare consequences, it could eliminate the entire benefit of what you were trying to do. Here are the differences in part B premiums for different income ranges:
And now for the Part D IRMAA:
Despite the premium increases from IRMAA, it can still make sense to eat those and do large conversions. A proper analysis must be done that accounts for how many years you will do conversions, where the tax will be paid from, what your estimated terminal tax rate is, and how a conversion will increase costs in other areas like Medicare premiums. The premium increases are not permanent, but evaluated one calendar year at at time. Recently I ran a Roth IRA conversion analysis for a client wanting to max out the 24% federal tax bracket and mapped out the changes in their anticipated Medicare premiums. You can see in 2023 they were hit with quite the adjustment under the column for total Medicare premium:
This was an example of a conversion strategy that did not make sense to implement. It actually would have reduced the client’s tax-adjusted terminal wealth by hundreds of thousands of dollars. But as I mentioned above, sometimes it CAN make sense to pay higher Medicare premiums (although most do not find it enjoyable).
Another aspect to consider on a Roth IRA conversion is the Medicare net investment income tax. This is a 3.8% tax rate assessed against the lower of your net investment income, or the amount you go over one of the below thresholds for modified adjusted gross income:
Sooner or later you must start withdrawing from your pre tax retirement accounts. Currently you are required to start taking distributions in the year you turn 72 (although there is currently a bill in Congress that would push this back until age 75). Converting money to a Roth IRA before age 72 may not only reduce your future tax liability but also reduce the amount you may not need or want to take from the account from 72 onward. I have evaluated many scenarios where required minimum distributions can throw people into a higher marginal bracket, and proactive planning can help avoid that.
There are situations where it can make sense to utilize Roth IRA conversions prior to age 59.5. The biggest caveat to be aware of is that withholding taxes on the conversion is considered a premature distribution and assessed and 10% penalty on top of regular income tax.
It has become a popular strategy over the last decade+ to utilize a backdoor Roth IRA for high income individuals. While there are income limits on who can contribute money into a Roth IRA, there are not income limits for traditional IRA contributions. The traditional IRA incomes limits only apply to the deductibility of the contribution, not the contribution itself. This opens up the backdoor entry to a Roth.
Example: Janie and Timmy Warbucks make $250,000 annually and want to make Roth IRA contributions. Their astute financial planner at Meredith Wealth Planning has them both open traditional IRAs and Roth IRAs. They each contribute the max of $6,000 to the traditional IRA. A few days later the balances are converted from the traditional IRA to the Roth. They receive a 1099-R at the end of the year showing the distribution from the IRA with very little if any taxable amount since the balance was only in the IRA for a few days and didn’t have much time to grow.
Below are the phase out limits that apply to contributions directly into a Roth IRA.
There is a big caveat to be aware of when it comes to the backdoor Roth IRA contributions. If you already have a pretax IRA , SEP IRA, or SIMPLE IRA balance then the backdoor Roth may not be a great option. The taxability of the conversion is on a pro-rata basis. If the nondeductible contribution you make to a traditional IRA only accounts for 5% of all your existing traditional IRA balances, then 95% of your conversion will be subject to taxation!
One way around this pro rata rule is to consider rolling over your traditional IRA balances into your workplace 401k plan, if possible.
Alright things are heating up now, if you’ve made it this far then I suspect you’re truly dedicated to your finances. That is appreciated. My wife was on the fence about marrying me until I told her about the Mega Backdoor Roth IRA strategy. She said she knew I was the one the second I mentioned above-the-limit contributions. Sorry guys, this charm cannot be taught. Moving on…
We know if you’re under 50 years old you can contribute $19,500 annually to a 401k plan. Your employer contributions are on top of that limit. If you’re over 50 you can defer $26,000. Now this is where it gets spicy. Between you and your employer you cannot have a total contributed during the year above $58,000 ($64,500 if you’re over 50).
It’s not unusual today for 401k plans to offer voluntary after-tax contributions. This is an amount you can contribute above the normal employee limits, but still must stay under the aggregate limit between you and your employer. The neat thing is that more and more 401k plans are allowing these after tax contributions to be converted into the Roth 401k bucket via in-plan Roth conversions, or rolled into an external Roth IRA annually. This means you are socking away extra money into a Roth that you never would have been able to previously.
Any gains on the after-tax contributions would be subject to income tax upon the conversion, but a plan may even allow the gains portion to be rolled into a traditional IRA and avoid current taxation altogether.
Each Roth IRA conversion is subject to a 5 year rule. This means you have to wait 5 years to withdraw that conversion from the Roth IRA tax-free. Even if you were to do a conversion in December of 2021, it is assumed for the 5 year purpose that you did it on January 1, 2021. You can shorten the 5 year rule to a little over 4 year rule by doing these at the end of the year, but the tradeoff is then you have less time in the Roth.
If you’re over age 59.5 the 5 year rule still applies, but the 10% early penalty does not. If you break the 5 year rule at age 65 you could pay ordinary income taxes on the gains that were made since your conversion was done, but you will not pay a penalty tax on the amount.
If you are in a lower income bracket and the only reportable income you have is your Social Security, then extra scrutiny is required on the Roth IRA conversion analysis. There are scenarios where a $10,000 Roth IRA conversion could add $15,000 – $20,000 to your taxable income because of the way Social Security income is taxed.
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