For a long time, converting your traditional IRA to a Roth version was a fairly low-risk proposition. If you changed your mind at a later date, you could always reverse course. That ended with the tax bill former President Trump signed in December 2017.
The legislation abolished the option to “recharacterize” a Roth conversion back into a traditional, SEP, or SIMPLE IRA, beginning in the tax year 2018. It did the same for Roth IRA funds rolled over from 401(k) and 403(b) accounts. There was a brief window until Oct. 15, 2018, in which you could still undo a 2017 Roth conversion. Needless to say, the deadline has passed.
- If you converted to a Roth in 2017, you missed out on lower tax rates. It's too late to reverse that conversion.
- However, if you have a traditional IRA or 401(k), today's historically low rates should have you considering converting to a Roth.
- The new rates are in effect until 2025.
On the upside, we've got historically low tax rates right now. So, converting a traditional IRA or 401(k) to a Roth and keeping it there makes more sense than ever. Unless that is, you're counting on tax rates going even lower than the 10% to 37% rates that are locked in now until 2025.
Effect of Tax Rate Changes
With a traditional IRA, savers contribute on a pre-tax basis and pay ordinary income tax rates when they withdraw the funds in retirement. A Roth IRA offers similar benefits but in reverse. You pay ordinary taxes now in order to make tax-free qualified withdrawals down the road.
Switching to a Roth makes the most sense if paying Uncle Sam now results in a lower tax liability overall. Take, for example, a married couple who converted their $200,000 traditional IRA account—consisting entirely of pre-tax money—into a Roth in 2017 prior to the Tax Cuts and Jobs Act. Let’s further suppose that they had $100,000 of other taxable income.
Under the previous tax law, their $200,000 account would have been subject to a 33% income tax rate for 2017. (Any previously untaxed money that you reclassify as a Roth gets added to your adjusted gross income for tax purposes.) The conversion alone would result in a $66,000 payment to Uncle Sam. Meanwhile, $200,000 in income is only taxable at 24% in 2021 for those married filing jointly.
The Tax Cuts and Jobs Act (TCJA) lowered marginal tax rates for individuals. The updated tax rates from the TCJA are set to expire in 2025. Here is a look at the tax rates for 2022.
|2022 Tax Rates|
|Rate||Married Joint Return||Single Individual||Head of Household||Married Separate Return|
|10%||$20,550 or less||$10,275 or less||$14,650 or less||$10,275 or less|
|12%||Over $20,550||Over $10,275||Over $14,650||Over $10,275|
|22%||Over $83,550||Over $41,775||Over $55,900||Over $41,775|
|24%||Over $178,150||Over $89,075||Over $89,050||Over $89,075|
|32%||Over $340,100||Over $170,050||Over $170,050||Over $170,050|
|35%||Over $431,900||Over $215,950||Over $215,950||Over $215,950|
|37%||Over $647,850||Over $539,900||Over $539,900||Over $323,925|
Unwinding that conversion before October 15 might have been a wise move. If the couple redid the Roth conversion in 2018 at today’s lower rates, they could have saved some serious bucks, assuming their account balance remains unchanged. By the same token, a couple in the same bracket in 2021 would be able to convert a traditional IRA or 401(k) and pay for the conversion at today's lower rates.
To Wait or Not to Wait
Keep in mind that the individual income tax cuts passed into law are expected to be in effect until 2025. Congress may extend the cuts or enact a very different tax law. It's impossible to predict.
One sure thing is that today's tax rates are relatively low. And, assuming you continue contributing money and that your money keeps on making money, your account will grow. Every year, it will be harder to pay the income tax bill that comes with a Roth conversion.
But the biggest attraction of a Roth is that you should owe no money on the account ever again. When you start taking the money out, presumably after you retire, you will owe no further taxes on the principal or the earnings as long as you take qualified distributions.
That differs from a traditional IRA or 401(k), in which you pay income taxes on both the principal and the earnings as you make withdrawals.
Also, keep in mind that you don’t have to convert all your funds at one time. You can limit your tax hit by spreading out the process over multiple years, converting just enough to stay in your current bracket.
Internal Revenue Service. “IRA FAQS - How Does the Effective Date Apply to a Roth IRA Conversion Made in 2017?”
Internal Revenue Service. "Topic No. 451 Individual Retirement Arrangements (IRAs)."
Tax Foundation. "2017 Tax Brackets."
Internal Revenue Service. "26 CFR 601.602: Tax forms and instructions."
Debt.org. "2020-2021 Tax Brackets."
Internal Revenue Service. "IRS Provides Tax Inflation Adjustments for Tax Year 2022."
Internal Revenue Service. "Distributions from Individual Retirement Arrangements (IRAs)," Page 32.
Internal Revenue Service. "Traditional and Roth IRAs."