Clients often consider whether it’s wise to convert their individual retirement accounts to Roth IRAs. There are pros and cons to doing so. But, for some clients, the Tax Cuts and Jobs Act of 2017 may tip the scales in favor of converting substantial amounts now.
Benefits of Roth Conversion
There are several benefits to converting to a Roth IRA. Principal among them is that, assuming the IRA owner has other funds to pay the tax on the conversion, the IRA owner is effectively shifting additional wealth into the IRA.
Example: Assume a constant 25 percent income tax bracket. An IRA owner has a $100 traditional IRA and $25 in a taxable account. If he converts, he has a $100 Roth IRA. Over some period of time, it grows to $200, all of which is tax free. Over the same period of time, if he doesn’t convert, his traditional IRA will grow to $200, or $150 after income tax. His $25 taxable account will grow to less than $50, because the income and gains on that account will be taxable each year.
There are several other benefits to the Roth conversion as well: There are no required minimum distributions (RMDs) during the IRA owner’s lifetime or the lifetime of his spouse if the spouse is the beneficiary. A Roth conversion increases the level of asset protection in states where they’re protected against creditors. If the IRA owner leaves the IRA to his beneficiaries in trust, rather than outright, the trust tax rates won’t apply to distributions from the Roth IRA that are accumulated in the trust. The Roth conversion also avoids double taxation in states that have a state estate tax.
Lower Income Tax
There’s often an income tax tradeoff in converting to a Roth IRA. As a general rule, the Roth conversion makes sense to the extent the tax rate on the conversion is less than, equal to or not “too much” higher than the tax rate that would otherwise apply to distributions from the IRA. That’s why many IRA owners spread the conversion out over a number of years or wait until they retire to convert or to begin to convert. By reducing tax rates basically across the board, The Tax Act may greatly simplify this decision for many IRA owners.
Wider Tax Brackets for Joint Returns
In addition to reducing the tax rates, the Tax Act also widened the tax brackets on joint returns to double the width of those for singles in every bracket.
For many years, the tax brackets for joint returns were twice the “width” of those for single taxpayers.
To provide relief for singles, the Tax Reform Act of 1969 changed the brackets so that if two individuals with similar incomes married, their tax would increase (resulting in a marriage penalty). However, if two individuals, only one of whom had income, were to marry, their tax would decrease (resulting in a marriage bonus).
To ameliorate the marriage penalty, the Economic Growth and Tax Relief Reconciliation Act of 2001 widened the 10 percent and 15 percent brackets on a joint return to be twice the width of the corresponding brackets for single returns. To balance the interests of singles and married couples, the joint return brackets above 25 percent were wider than, but not double, the width of the corresponding single brackets.
The Tax Act expanded this doubling.
For single individuals, the regular income tax rates in 2018 are: 10 percent up to $9,525, 12 percent up to $38,700, 22 percent up to $82,500, 24 percent up to $157,500, 32 percent up to $200,000, 35 percent up to $500,000 and 37 percent over $500,000.
In comparison, for joint returns the rates are: 10 percent up to $19,050, 12 percent up to $77,400, 22 percent up to $165,000, 24 percent up to $315,000, 32 percent up to $400,000, 35 percent up to $600,000 and 37 percent over $600,000.
Under the new rates, many IRA owners will convert each year to the extent they can do so in the 10 percent or 12 percent income tax bracket. Other IRA owners may convert each year to the extent they can do so within the 22 percent or 24 percent bracket. IRA owners who expect that they and their beneficiaries will always be in a very high tax bracket may convert their entire IRA as quickly as they can.
Of particular note are the 22 percent and 24 percent brackets. Since on a joint return these brackets are now twice the width of the corresponding single brackets, this newfound breadth offers a window for many middle- and upper-middle-income IRA owners to convert substantial amounts to a Roth IRA within the 22 percent or 24 percent brackets.
This conversion is especially attractive to many IRA owners who’ll always be in at least the 22 percent bracket as a result of pensions, Social Security, RMDs and investment income.
This is an adapted version of the author’s original article in the June 2018 issue of Trusts & Estates.