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Why You Should Consider a Roth IRA Conversion Before Year’s End

Alli Thomas

If you’ve been thinking about doing a full or partial Roth IRA conversion, now is the time to take action. The year is almost over. That means you probably have a pretty good idea of what your total annual income will be. This should help give you a clearer picture of how much of a conversion you can afford to do without crossing into a higher tax bracket.

We talk about the Roth a lot here. It’s grown more popular since 1997, when it was created. By 2018, nearly 22.5 million of these accounts had been established. Still, more Americans have traditional IRAs than Roth IRAs. And most of the money in traditional IRAs comes not from contributions, but from 401(k) plan rollovers.

So why should you be thinking about doing a Roth conversion?

Many financial experts believe that the Tax Cuts and Jobs Act of 2017 (TCJA) reduced federal income tax rates to the lowest level they may ever be. Here are the rates for 2021:

Rate  Single  Married Filing Jointly   Head of Household 
10% Up to $9,950 Up to $19,900 Up to $14,200
12% $9,951 to $40,525 $19,901 to $81,050 $14,201 to $54,200
 22% $40,526 to $86,375 $81,051 to $172,750 $54,201 to $86,350
 24% $86,376 to $164,925 $172,751 to $329,850 $86,351 to $164,900
 32% $164,926 to $209,425 $329,851 to $418,850 $164,901 to $209,400
 35% $209,426 to $523,600 $418,851 to $628,300 $209,401 to $523,600
 37% $523,601 or more $628,301 or more $523,601 or more

 

TCJA includes a sunset provision for tax rates. They are scheduled to return to their pre-2018 amounts in 2026. But it’s possible that our current tax rates may not even make it to that point. Political control changes may cause the lower rates to revert sooner than expected.

An example of how TCJA has made Roth conversions more attractive

Let’s say that you were in the 33% marginal tax bracket before TCJA was passed. But since 2018, you’ve shifted to the 24% tax bracket. If you were to do a Roth conversion this year, you’d pay less in federal income taxes on the amount you convert than you would have before TCJA.

That may sound great. But what if you’re trying to avoid taking a huge tax hit in a single year? No problem! Assuming the lower tax rates remain until 2026 as planned, you may choose to convert smaller amount of your traditional IRA to a Roth IRA every year through 2025.

Here’s another example. Let’s say you’re single and will earn about $125,000 this year. This would put you in the 24% tax bracket.

Now let’s say you have $75,000 in a 401(k) plan with a former employer. If you converted all of it to a Roth IRA this year, you’d be taxed at the next higher marginal rate (32%) on nearly half of the conversion amount.

Instead, you could do several smaller partial conversions and spread them over a number of tax years. If your income remains about the same each year, your Roth conversions would be taxed at the 24% marginal rate.

Another benefit of TCJA is that the width of some joint-return tax brackets have been doubled to twice the size of the single filer bracket. Taxpayers in these brackets can now do Roth conversions on larger amounts without having to worry about being pushed into a higher tax bracket. If you’re married and in the 22% or 24% marginal brackets, you should seriously consider doing a Roth conversion before 2026.

There is one downside that TCJA brought for Roth conversions. Before 2018, Roth conversions could be reversed via a recharacterization. That’s no longer the case. If you’re wondering why anyone would want to do that, here’s the reason: if your account took a hit from a market decline, reversing your Roth conversion could help you avoid paying tax on money that was no longer there. But TCJA took this reversal option off the table.

If you’ve been thinking about doing a full or partial Roth IRA conversion, now is the time to take action. The year is almost over. That means you probably have a pretty good idea of what your total annual income will be. This should help give you a clearer picture of how much of a conversion you can afford to do without crossing into a higher tax bracket.

Ready to talk about doing a Roth conversion before year end? Our financial professionals are here to answer all your questions—at no cost and with no obligation. Click here to schedule an appointment with one of them today.

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