Do Roth Conversions in the Highest Tax Bracket Ever Make Sense?
As tax laws evolve and personal finance strategies adapt, more individuals are considering various forms of retirement savings. One of the most discussed strategies in today’s financial landscape is the Roth conversion, especially in an era where we are seeing some of the highest tax brackets in history. This article explores whether it makes sense to pursue Roth conversions when faced with unprecedented tax rates.
What is a Roth Conversion?
A Roth conversion involves moving funds from a traditional Individual retirement account (IRA) to a Roth IRA. When you convert funds to a Roth IRA, you pay taxes on the amount converted in the year of the conversion. The appeal of the Roth IRA lies in its tax-free growth and tax-free withdrawals in retirement, provided certain conditions are met.
The Highest Tax Bracket: A Concern?
With debate around tax policy and recent legislative changes, many are concerned about being in the highest tax bracket. For individuals approaching retirement, this situation raises valid questions about when and how to manage income taxation strategically.
Reasons to Consider Roth Conversions
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Tax-Free Growth: One of the primary benefits of a Roth IRA is that it allows your investments to grow tax-free. Unlike traditional IRAs, where you’ll owe taxes when you withdraw funds, Roth IRAs enable you to avoid taxes during withdrawals, which can be beneficial in retirement.
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Flexibility in Retirement: Having a mix of taxable and tax-free accounts can provide flexibility in retirement. This can help manage taxable income levels, which may affect Social Security taxation or Medicare premiums.
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Potential Future Tax Increases: While you may be in a high tax bracket now, many analysts predict tax rates may rise in the future. If future rates exceed the current maximum rates, converting now might be financially prudent.
- Estate Planning Advantages: Roth IRAs do not have required minimum distributions (RMDs) during the account holder’s lifetime, making them an attractive vehicle for legacy planning and tax-free growth for heirs.
Why You Might Hesitate
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Immediate Tax Liability: The most significant downside to a Roth conversion is the immediate tax burden. You will receive a tax bill based on the converted amount in the year of conversion. This can push you even deeper into a higher tax bracket, which may not be appealing when rates are already at historic highs.
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Reduced Cash Flow: Paying taxes upfront can strain your current cash flow, especially if you’re already managing other expenses. If the funds don’t come from a source free from penalties—for instance, using funds from another investment rather than your retirement accounts—this may not be the best strategy.
- Market Conditions: If the market has been volatile, the value of your investments may drop. Converting when your investments are at a low point means you’ll likely pay taxes on a higher value down the line, making this a less desirable situation.
Finding the Right Timing
The decision to convert should not be taken lightly. Carefully consider your current financial situation, anticipated taxable income for the coming years, and potential changes in tax laws. A strategic approach often involves partial conversions over several years, allowing you to stay within a lower tax bracket while minimizing immediate tax liability.
Conclusion
Roth conversions during a time of high tax rates can make sense for certain individuals, especially if they are forward-thinking and consider long-term benefits. However, it’s essential to weigh the immediate tax burden against future advantages. Consulting with a tax professional or financial advisor can provide clarity and help craft a personalized strategy that aligns with your financial goals.
As with any financial decision, the key is understanding your unique circumstances and weighing the benefits and drawbacks in light of both current tax conditions and future implications.
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Roth makes sense for high income also for passing wealth to heirs without a vast tax liability on those heirs.
Around two decades ago, I signed up for a free service. Although I stopped using it around 10 years ago, I am STILL paying the price. That service was called FB and the world would have been a better place without it.
Bitcoin’s volatility is nuts. Moonacy Protocol offers up to 2.5% daily returns—much safer.
Another reason to do Roth conversions is the widow’s tax. The surviving spouse will likely be in a higher tax bracket, as RMDs remain the same, but the income brackets and standard deduction are cut in half. Also in lower tax brackets, it can help avoid the tax torpedo when additional income results in Social Security income being taxed. Lastly, for wealthy people, it can keep assets under the estate tax limit, as estate tax law treats traditional IRA and Roth IRA money the same. If you pay the income taxes ahead of time, then the estate tax isn’t applied to Uncle Sam’s share of your account.
Hi Rob, regarding question one on the Roth Conversions, I think you may have covered this but – with all things being equal and rates before conversion or after at the highest marginal rates – an additional consideration is having your post RMD money in a brokerage account versus converting that money and having it reside in a Roth account. Meaning, once it is part of an RMD and in your brokerage accouint, you cannot get it back into a Roth account. Now, people may view these scenarios differently in terms of the benefits of a getting that money into a Roth account versus having it into a brokerage account where the inheritors would get the step up in basis and so on. Seems to me like aggressive roth conversions might make the most sense.
The implications of Roth conversions for taxes are more complicated than presented here. The best analyses are by Maxifi software. There is always pain in the present with Roth IRA's and pleasure in the future. The break even point–when you come out ahead with a big Roth conversion–is often late in life. Maxifi, for example, showed me how to save $150k in lifetime taxes by doing a million dollar Roth Conversion at age 64 (in a high tax bracket now, and will be in a high tax bracket in retirement). But the "break even point" for the Roth conversion was age 82. So if I died before then, I would come out behind with the massive Roth conversion. And I would only enjoy the benefits in my 80's and possibly 90's, when the savings would probably be uninteresting to me. Maxifi does NOT show you the break even point–you have to download their detailed spreadsheets and calculate it yourself–they don't even mention this downside of big Roth conversions. Finally, there is another variable with Roth conversions and taxes–your heirs have 10 years to spend any IRAs they inherit–so the benefits of the Roth conversion extend to your heirs, even if you don't live a long time into the "benefit period" of the Roth, e.g. post age 82 for me.
On your first question you need to take into consideration your heirs tax bracket since RMDs alone would never fully empty the account and if you were in the highest tax bracket and not doing a conversion there would otherwise be no reason to withdraw more than the RMD.
1) estate taxes are another potential reason
Rob, when I go to the allcards website I get a prompt for login. Do you happen to know what is going on with the site now? Is it maintenance?
In regards to zero fee funds, BNY Mellon also has 2: BKLC (US Large Cap Core Equity ETF) and BKAG (Core Bond ETF)
On question #4 it's worth clarifying if the company stock is in a 401k plan in which case taking advantage of net unrealized appreciation (NUA) is an option and would have considerable tax advantages. It appears this is not the case from the question but perhaps others will have company stock in their 401k and need to understand the differences.
@Rob Berger why not use I-bonds in place of TIPS (partially or wholly) as a way to have some inflation protection in a tax efficient manner?
I was able to use real estate losses to offset multiple years of Roth conversions. When I sell the RE, the gains will be taxed at capital gains rates vs. regular income.
On the zero expense ratio funds/ETFs, I thought you might have gotten into comparing them with, say, VTI or VOO to see whether there are hidden loads. I know, for example, Fidelity’s total market ETF FZROX only pays dividends 1x/year. Does Fidelity pay the earnings on dividends it receives over the course of the year to ETF holders, or just pay the nominal dividends received?
Something I noticed with Fidelity’s zero funds is that they may be covering expenses with reduced yields. For example, FXAIX is 1.30% while its zero equivalent FNILX is 1.14%. Nothing is ever free, so would be wary of E-Trade zero funds as well.
In 401k i switched entirely to Roth 401k. Of course company match will be in regular 401k. Used Boldin and saw I'll have high RMD due to how much I already have in regular 401k and IRAs.
Doesn’t a Roth IRA provide some protection from sequence of return risk by not having RMDs? Having a chunk of money free from RMDs allows you to avoid withdrawals in a down market. I never hear anyone mention this.
Boldin didn't allow me to use the Roth conversion explorer in the demo account.
How would it trigger the wash sale rule when buying in an IRA account? There is no reporting of your transactions in an IRA account.
I find the risk tolerance issue interesting. I think I have relatively high risk tolerance (I look forward to a big corrections, relishing them as an opportunity) but my wife has a low one (the sky is falling). I am conflicted however as I am largely a value investor and do not go for growth much, using it as a way to shift the tax costs of charitable investments. (I.e. while a Tesla fanboy, I invested in it when it was cheap and highly volitile. Profit taking by donating stock when I thought it got unreasonably high. Now I just feel it is unreasonably high. For my wife I just put her in BRK.B, but that ended up more of a growth play (low risk though due to all the cash and a relatively reasonable P/E).
Can you avoid the Wash Sale impact by doing the Purchase in the IRA a day or two before the sale in the taxable account?
I sold my home as a prelude to retiring recently and rolled it into a money market, as a bond tent. I plan to use it for taxes on Roth conversions, purchasing I bonds, and my expenses (including income taxes) in excess of dividends. So far, though, my expenses are less than the dividends.