The Tax Cut and Jobs Act (TJCA) made significant changes to personal income tax rates and tax brackets in 2018. These lower rates and wider brackets likely represent a short-lived window to reduce lifetime income taxes by converting traditional IRA funds to Roth IRAs. This is because the TCJA’s personal tax provisions are set to expire in 2025, at which point we will be back to the 2017 and earlier rates and brackets for 2026 and beyond unless Congress acts to extend the tax cut. There is also an election coming in 2020, which could trigger an earlier and more significant change to the tax landscape.
How significant is the Roth conversion opportunity today? Consider a married couple with taxable income of $165,000. The TCJA puts them in the 22% marginal tax bracket. If the 2017 rates and brackets come back into play, their marginal tax rate on the same income will be 28%. Consequently, it makes sense to pay tax now at less than 28% on income that will eventually be taxed at 28% (or higher). Remember that IRA owners must start withdrawing funds from these accounts once they reach age 70 ˝, regardless of whether they need the income. By moving funds from a traditional IRA to a Roth IRA now, today’s tax rate is locked in and future withdrawals from the Roth IRA will be tax-free.
The trick in determining how much of an IRA should be converted to Roth is figuring the additional tax that will be due on the converted funds. Sometimes, this is as simple as knowing your marginal tax rate, but often other taxes and costs come into play, particularly at higher income levels. For example, the long-term capital gains tax rate jumps from 15% to 20% for higher income taxpayers. Fortunately, the threshold for this rate change is quite high ($488,850 for married filers and $434,500 for singles) so this should only impact very large Roth conversions. The Net Investment Income (NII) tax, however, may enter the mix for anyone trying to fill up lower tax brackets with Roth conversions. The NII is an extra 3.8% tax applied to the lesser of Net Investment Income or the amount by which Modified Adjusted Gross Income exceeds $250,000 for a married couple ($200,000 for single filers).
Taxpayers who have already reached Medicare age (65) and started collecting Social Security face additional complications when computing the tax on Roth conversion income. Social security recipients with lower incomes must account for the fact that more of their social security income will be taxable if they add on income from a Roth conversion. Here, even a small Roth conversion can cause a significant increase in the effective tax rate on the conversion. For social security recipients who are already paying tax on 85% of their social security income (the highest amount), this is not an issue, but Roth conversions can trigger a significant increase in Medicare premiums that must be accounted for. Once Modified Adjusted Gross Income (MAGI) exceeds $170,000 for a married couple, the Medicare Part B premium increases $54.10 to $189.60. Consequently, a Roth conversion to fill up the 22% marginal tax bracket, which tops out at taxable income of $165,000, will likely trigger this additional Medicare premium plus a Medicare Part D income adjustment of $12.40 per month. So, for a couple age 65 or over, the tax rate on a Roth conversion to the top of the 22% tax bracket would be 22% of the converted amount plus $1,596 in additional Medicare premiums in the following year. Additional income-based adjustments to Medicare premiums come into play at higher levels of MAGI which can add a few thousand dollars to the cost of a conversion.
Even when these additional taxes and costs come into play, Roth conversions can significantly reduce a retiree’s lifetime tax burden given today’s low-tax-rate environment. Retiree’s with large IRAs and other sources of retirement income like social security and pensions could see their tax rate jump to 33% or more once they must start taking required minimum distributions. Those who have yet to turn on their social security benefits may want to consider delaying these as long as possible to take advantage of the opportunity to shift more of their IRA assets to Roth before hitting RMD age.
David T. Mayes is a CERTIFIED FINANCIAL PLANNERTM professional and IRS Enrolled Agent at Bearing Point Wealth Partners, Inc., a fiduciary financial planning firm in Hampton. He can be reached at (603) 926-1775 or firstname.lastname@example.org.