The TCJA Makes Roth IRA Conversions More Favorable
When tax laws change, the cost/benefit analysis on many financial planning strategies changes as well. The 2017 Tax Cuts & Jobs Act (TCJA) lowered most taxpayers’ top marginal federal tax bracket.
Lower rates improved the outlook on a strategy we expect to implement more often: Roth conversions. To understand Roth conversions, it’s first important to review a basic account structure and the differences between the two tax-advantaged retirement savings accounts.
The below chart illustrates a non-retirement account structure. Let’s say you pay 30 cents of every dollar you earn in taxes. You can deposit the remaining 70 cents in a taxable account and invest to generate growth. Along the way, you will pay taxes on interest, dividends, and gains when you sell investments.
Tax-advantaged retirement accounts offer preferential tax treatment. The first type, tax-deferred accounts (e.g. 401(k), 403(b), 457, or IRAs), allow you to deposit pre-tax dollars. You can invest 100 cents of every dollar earned, and the account grows without taxation. You pay taxes upon withdrawal.
Like taxable accounts, in a tax-free Roth account you invest after-tax dollars. The advantage is that the 70 cents invested grows tax-free. And unlike taxable and tax-deferred accounts, there are no taxes due upon withdrawals.
Roth IRA Conversions
Most people have much more savings in tax-deferred retirement accounts than Roth accounts. Reasons include: (a) restrictions on Roth IRA contributions, (b) workplace retirement plans that do not offer a Roth option, (c) pre-tax employer contributions, and (d) a preference to reduce current year taxes.
At any time, a saver can convert pre-tax IRA assets to Roth IRA assets. The amount converted is treated as taxable income on that year’s tax return. For example, a saver in the 24% marginal federal tax bracket who converts $10,000 from her IRA to a Roth IRA owes $2,400, plus applicable state taxes.
The main consideration whether to convert tax-deferred to Roth is your current and future tax brackets. If your bracket will be higher when you take distributions, then it is preferable to pay taxes now (Roth) and receive tax-free growth. If you expect that your bracket will be lower, then better not to pay taxes now (tax-deferred) and instead pay at the future lower rate.
Of course, this analysis depends on comparing a known (today’s tax rates) versus an unknown (future rates). The unknown variables include not just your future years’ income but even what tax rules will be.
Despite the guesswork, the TCJA has tipped the analysis more in favor of Roth conversions. Most prominent, today’s lower rates have reduced the known variable: the taxes owed upon conversion.
Second, lowered rates make it likelier that future law changes increase rates, especially because today’s rates are historically on the low side.
Third, we preach diversification in our portfolios. Similarly, there are benefits to diversifying the tax status of your investments. The TCJA is a reminder that rules can and will change. Dollars in a tax-free account can insure against the risk that tax rates will be much higher. Also, money with different tax statuses allows us to strategize how to take distributions tax efficiently.
We will have a renewed focus on Roth IRA conversions this year. They will not make sense for everyone. We plan to evaluate and reach out to clients by year end if we believe that they would benefit from this strategy.