Roth conversion makes sense at today’s low tax rates

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

The legislation removed the option to “recharacterize” a Roth conversion back into a traditional, SEP, or SIMPLE IRA beginning in the 2018 tax year. It did the same for Roth IRA funds transferred from 401(k) and 403(b) bills. There was a short period until October 15, 2018, when you could undo a 2017 Roth conversion. Needless to say, the TBEN has passed.

Key learning points

  • If you switched to a Roth in 2017, you missed out on lower tax rates. It’s too late to undo that conversion.
  • However, if you have a traditional IRA or 401(k), you should consider switching to a Roth because of today’s historically low rates.
  • The new rates will apply until 2025.
  • It is not mandatory to convert all funds at once.
  • If eligible, an account holder can withdraw Roth contributions and income tax-free.

On the upside, we currently have historically low tax rates. So it makes more sense than ever to convert a traditional IRA or 401(k) to a Roth and keep it there. Unless that’s the case, count on tax rates to be even lower than the 10% to 37% rates now set through 2025.

Effect of changes in tax rates

With a traditional IRA, savers contribute before taxes and pay regular income tax rates when they withdraw the money in retirement. A Roth IRA offers similar benefits, but in reverse. You pay regular taxes now to make tax-free qualified withdrawals later.

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

Under the previous tax law, their $200,000 account would have been subject to a 33% income tax rate for 2017. (Any previously untaxed money that you reclassify as a Roth will be 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 in income is taxable at 32% in 2022 and 2023.

The Tax Cuts and Jobs Act (TCJA) lowered marginal tax rates for individuals. The TCJA’s updated tax rates expire in 2025. View the tax rates for 2023 here.

Tax rates 2023
Rate Married Joint Return Single individual Head of the household Married Separate return
10% $22,000 or less $11,000 or less $15,700 or less $11,000 or less
12% $22,000 – $89,450 $11,000 – $44,725 $15,700 – $59,850 $11,000 – $44,725
22% $89,450 – $190,750 $44,725 – $95,375 $59,850 – $95,350 $44,725 – $95,375
24% $190,750 – $364,200 $95,375 – $182,100 $95,350 – $182,100 $95,375 – $182,100
32% $364,200 – $462,500 $182,100 – $231,250 $182,100 – $231,250 $182,100 – $231,250
35% $462,500 – $693,750 $231,250 – $578,125 $231,250 – $578,100 $231,250 – $346,875
37% $693,750 and up $578,125 and up $578,100 and up $346,875 and up

It would have been a wise move to complete that conversion before October 15. Had the couple redoed the Roth conversion in 2018 at today’s lower rates, they could have saved quite a bit of money, assuming their account balances remain unchanged. Similarly, a couple in the same category could convert a traditional IRA or 401(k) in 2022 and pay for the conversion at today’s lower rates.

To wait or not to wait

Keep in mind that the individual income tax cuts that have passed into law are expected to be in effect until 2025. Congress can extend the cuts or pass a completely different tax law. It’s impossible to predict.

One thing is certain: current tax rates are relatively low. And assuming you keep contributing money and your money keeps making money, your account will grow. Every year it will be more difficult to pay the income tax bill associated with a Roth conversion.

But the biggest appeal of a Roth is that you never have to have money in the account again. When you begin withdrawing the money, presumably after you retire, you will not owe any further taxes on the principal or income as long as you receive qualified distributions.

That’s different from a traditional IRA or 401(k), in which you pay income taxes on both principal and income as you withdraw money.

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