Is Now the Time for a Roth Conversion?
Now that the tax cuts have had time for the dust to settle, what are you going to do about it? By now you are seeing a little more money in your paycheck and a good idea would be to save that extra dough. However, that’s not what this is about. From a big picture perspective, how do you take advantage of lower tax brackets? Let’s look at Roth IRAs more closely.
What is a Roth?
Roth IRAs (or 401ks/403bs) were established in 1997 through the taxpayer relief act which was sponsored by Senator William Roth of Delaware. A Roth’s tax treatment is pretty much exactly the opposite of a Traditional IRA or 401k plan. Money that has already been taxed will go into the Roth, the money will grow tax free and it can be taken out tax free in retirement (after age 59 ½).
What are the Advantages of a Roth?
Unlike a Traditional IRA, any money that a person contributes to a Roth IRA can be withdrawn penalty free since the money has already been taxed. Medicare costs (Part B and Supplements) in retirement are based on income, but withdrawals from Roth IRAs do not count. Distributing money from a Roth IRA can help you reduce your Medicare expenses.
Does it Make Sense to Pay Taxes Now or Defer them to Retirement?
To answer that question, we should first look at historical tax rates. In 2017, the highest marginal tax rate was 39.6% on individuals making over $418, 401. Historically speaking, this tax rate was relatively low. In 1944, the highest marginal rate was an unimaginable 94% which quickly trickled down over time to 70% by 1965. By the late 80s, the highest marginal tax rate dropped below 40%. Below is a chart that looks at the historical tax rate over the last 100 years.
After looking at the chart, it’s safe to say we are currently in a low tax environment. Currently, the highest tax bracket is 37% and you must make over $500,000 to hit that mark. These new tax cuts are set to expire in 2025. Based on historical data and the overwhelming amount of debt our country has, would you expect tax rates to be higher or lower in the future? If you think that taxes will be higher in the future, paying the taxes now could be a good strategy.
How About a Roth?
Roth IRAs can make a lot of sense for investors that are currently in a low tax bracket and expect to be in a higher tax bracket later in life. Roth IRAs can also be a fit for those that have a long time before they need to access the funds in the retirement account. Compounding interest and growth on a tax-free basis over time can be a powerful tool.
Unfortunately, the IRS limits Roth IRA contributions to $5,500 (with a $1,000 catch up provision for those over the age of 50). The IRS limits or denies the contribution ability of higher income earners. Those that earn $135,000 as an individual or couples who earn more than $199,000 can’t contribute to a Roth IRA. However, there is another way.
Roth Conversions
The IRS allows for a “loophole” for those that wish to contribute towards a Roth IRA because of course they would. This is where a Roth conversion comes in. You can take money in your IRA and convert it to a Roth IRA. You would have to pay income taxes on the full amount that you convert. For example, if you converted $100,000 from your IRA and you were in the 25% tax bracket, you’d have to pay taxes of $25,000 for the tax year. The $25,000 can be withheld from the money moving over (i.e. $75,000 is now invested in the Roth) or paid with normal cash flow. Moving forward, you’d never have to pay taxes again.