Roth accounts have become extremely popular for retirement planning. With historically low tax rates relative to where they are likely headed, tax free growth seems extremely appealing to retirement savers. However, Roth IRAs didn’t come into existence until 1998, and the Roth 401k version until 2006! Even still, many 401k and 403b plans don’t have Roth options available. Furthermore, you may have heard “you make too much money to contribute to a Roth IRA,” and never dug into the details. Therefore, many of you have likely accumulated large retirement account balances with “tax deferred” status and are wondering whether or not you should take advantage of Roth conversions?
Let’s talk about how this works and who might want to take advantage of this strategy.
How do Roth conversions work?
The first step is to have funds within your Traditional IRA or 401k (or 403b, TSP and 457b) you wish to convert. If you are still working and have limitations on in-service withdrawals or rollovers, this might be a challenge to convert your 401k to a Roth IRA (check plan rules to confirm). However, Traditional IRA’s can be converted at any time to a Roth IRA, regardless of employment status as well as adjusted gross income. The caveat is that you will likely have taxes due based on the amount converted. If you have $100k in a Traditional IRA that you never paid taxes on, and elected to convert the entire balance, you would have $100k added to your gross income for that tax year. You can pay the tax out of the balance of the conversion, but I highly recommend against doing this! Paying the taxes from the converted funds will reduce the amount you have invested in tax preferred status, which defeats the purpose of the conversion. Therefore, I advise paying the taxes from assets outside of retirement plans to maximize the amount that will grow tax free within the Roth IRA. If you are paying quarterly tax estimates, be sure to make an adjustment to your payment if you elect to make a substantial conversion during the year.
You might be aware that contributions are limited to a Roth IRA based on your adjusted gross income. See below for 2022 phaseouts.
|2022 Tax Year|
|Filing Status||Modified Adjusted Gross Income||Contribution||Catch up contribution (age 50+)|
|married filing jointly or qualifying widow(er)||less than $204,000||$6,000||$1,000|
|married filing jointly or qualifying widow(er)||$204,000 up to $214,000||a reduced amount|
|married filing jointly or qualifying widow(er)||$214,000 or greater||$0|
|married filing separately||less than $10,000||a reduced amount|
|married filing separately||$10,000 or greater||$0|
|single, head of household||less than $129,000||$6,000||$1,000|
|single, head of household||$129,000 up to $144,000||a reduced amount|
|single, head of household||$144,000 or greater||$0|
You read this correctly. If you are married and make above $204,000/year in MAGI (modified adjusted gross income), or single making above $144,000/year, you cannot contribute to a Roth IRA…directly. This leads us to reason #1.
Reason #1: You can’t contribute directly to a Roth IRA
If you make too much to contribute to a Roth IRA, you might consider contributing to a non deductible IRA first, and subsequently converting that contribution to a Roth IRA. This is also known as a backdoor Roth contribution. There is no income cap on making an after tax contribution to a Traditional IRA, you simply need earned income. The maximum contribution per year is $6,000 for 2022, with a $1,000 catch up contribution if you are 50 or older. Spouses are also eligible, regardless of income. Because the contribution was not tax deducitlbe in the first place, and you converted the assets immediately without any earnings or growth, there will likely be no tax consequences for the conversion. Instead, the amount converted will now enjoy tax free growth, just like a plain vanilla Roth IRA contribution would. I would argue that this loophole could be closed at some point given how popular it has become, so get it while the ‘gettings’ good!
The income phaseouts only apply to IRAs, NOT 401ks. Therefore, if you have the Roth 401k option available, you could elect to make contributions to the Roth 401k plan without worrying about an income cap. The 2022 maximum contribution is $20,500, with a $6,500 catch up provision for those 50 or older. Additionally, many 401k plans allow for what is known as a mega back door Roth 401k conversion. This allows for an additional non deductible contribution to be made into a 401k plan (over and above the regular maximum contribution), which is then automatically converted to the Roth 401k (in plan conversion). Here is a live example of a client I work with:
1. Max contribution of $20,500 into the Roth 401k
2. An additional $26,000 into the non deductible 401k
3. The $26,000 is then converted to the Roth 401k immediately
4. As a result, despite him making well above the income phaseout for Roth IRAs, he is contributing $46,500/year into his Roth 401k (wow!).
Be sure to read your retirement plan rules to see if your plan has this feature. This has already been on the chopping block for the IRS to shut down, so I would also expect significant changes to this rule very soon.
Lastly, if you are doing a backdoor Roth IRA contribution, be careful of the aggregation rule, which might exclude the amount that you can convert tax free based on other retirement accounts you own. In short, if you have other IRA accounts that have tax deferred balances, it’s likely the IRS will use a pro-rata rule to determine if you actually owe taxes on the conversion. Discuss this with your CPA and your trusted advisors before doing a back door Roth conversion! (or any Roth conversion, for that matter)
Reason #2: Tax Free vs. Tax Deferred
Tax free growth is the most powerful reason for choosing Roth over Traditional contributions, and ultimately deciding if you should convert some or all of your retirement assets to Roth. Traditional 401ks and IRAs will benefit from a tax deduction today. However, 100% of the growth and earnings on those accounts will be taxed at some point. If the market compounds at 8%/year over the course of several decades, that tax liability is getting bigger and bigger, and Uncle Sam is licking his chops! Roth accounts don’t enjoy a tax deduction, but all of the growth and earnings are tax free. Therefore, as the market compounds year after year, you never have to worry about the IRS getting their hands on your funds, as long as you follow the qualified distribution rules!
You might also expect tax rates to go up over time. With Social Security, Medicare and Medicaid needing a boost in funding, plus the massive stimulus pumped into the economy back in 2008-2009 as well as during the COVID-19 pandemic, it’s likely taxes could go up over time. Also keep in mind, the Tax Cuts and Jobs Act will sunset after 2025, pushing tax rates up for most Americans in 2026 and beyond (unless legislation changes this).
Therefore, if you expect taxes to at least stay the same, or more likely increase, you are probably better off converting your assets now while rates are low. Furthermore, I am writing this article while the NASDAQ is in a bear market and the Dow Jones index and S&P 500 have been on the brink of a bear market several times in 2022. Converting assets while the market is down will allow you to convert more shares with the same amount of money. This essentially gives you more bang for your back as the greater number of shares converted will enjoy tax free growth, in lieu of tax deferred growth.
Reason #3: Reducing your Required Minimum Distribution
I wrote an article about the tax trap of traditional 401ks and IRAs, and you can read it here. One of the big tax traps I run into working with retirees is the dreaded Required Minimum Distribution, or “RMD.” Once you turn 72, you are required to take out a certain percentage of all of your retirement accounts, EXCEPT for your Roth IRA! We’ve already established the Roth option is fairly new, so most of the baby boomer generation had very little exposure to these plans. There is an exception to the rule if you are still working that applies to funds within your employer’s 401k or 403b plans. Nonetheless, the RMD starts off at just under 4% @ age 72, and goes up each year as your life expectancy shortens. This can drastically increase your tax bracket over time in retirement. As an example, someone who turns 87 in 2022 will need to take out 7.3% of their account balance to satisfy their RMD. You might need the 4% withdrawal for income at the beginning of retirement to travel and enjoy your lifestyle, but you likely won’t need 7.3% of your account balance at 87 years old when spending will likely taper off. However, those RMDs need to be withdrawn, and taxes need to be paid, otherwise you are hit with a 50% penalty! Therein lies the tax trap. If you have some or all of your assets in tax free accounts, you can minimize or even avoid RMDs all together, and simply withdrawal what you need for retirement to supplement Social Security, Pension or other income, which is likely to significantly reduce the tax drag on your retirement.
Bonus tip: If you truly maximize the tax efficiency of your withdrawals, you will in turn minimize the tax impact of your Social Security income, which will give you a pay raise that keeps on giving in your golden years!
Reason #4: Saving money on Medicare premiums in retirement
We all pay into the system for Medicare while we are working. Everyone pays the same percentage for FICA during their working years. At age 65, you will enroll in Medicare and finally reap the benefits of paying into the system for multiple decades. However, if your income is above a certain threshold, you will pay more in Medicare premiums (see the chart below). This is known as IRMAA (income related monthly adjustment amount).
As mentioned before, Required Minimum Distributions can create a significant tax drag on your retirement plan, but now you know your health insurance premiums will be higher because you saved more for retirement! Let’s say you have $5,000,000 in a Traditional IRA and turn 75, your RMD will be $203,252 for 2022. Let’s say you also receive Social Security in the amount of $50,000 and your other investment income is $100,000. Your IRMAA will result in a surplus penalty of $4,490.40/year, despite paying the same amount into the system during your working years!
Now, let’s say that $5,000,000 retirement balance was instead a Roth IRA. We’ve already established Roth IRA’s have no RMDs, and furthermore the income is not counted as taxable. This means your taxable income would only be $150,000/year (using the same example above), which puts you into the lowest Medicare premium band.
If you take that savings of $4,490.40/year and multiplied it by 30 years, that’s a $134,712 in lifetime savings on Medicare costs!
Just remember, the income calculation for Medicare premiums have a two year look back period. Therefore, if you are taking advantage of Roth conversions early in retirement, you might have a few years of paying IRMAA, so you will need to calculate the long term benefits compared to paying higher taxes now in addition to higher Medicare premiums in the short term. Don’t let this deter you, especially if you have expected longevity in your gene pool.
Bonus tip: If you have a Health Savings Account (HSA), you can reimburse yourself tax free to pay the IRMAA and other healthcare costs in retirement. Leveraging an HSA is a powerful way to minimize the healthcare penalty of implementing Roth conversions once you are on Medicare. I wrote an entire article on HSA’s and how I believe it’s one of the most powerful retirement planning tools you can take advantage of. Check it out here.
Reason #5: Reducing widow/widowers income tax liability
It’s very uncommon for both spouses to pass away in the same year. It’s very common for one spouse to outlive the other for many years. My wife’s grandmother outlived her husband for over 15 years before she passed away @ 98 years old! The first two years after a spouse dies, the surviving spouse can still file as a qualifying widower, which has an identical tax bracket to those married filing jointly. However, after that second year, assuming they are not remarried, the surviving spouse will switch to a single tax payer status, which could substantially increase their taxes.
|Rate||For Unmarried Individuals||For Married Individuals Filing Joint Returns||For Heads of Households|
|10%||$0 to $10,275||$0 to $20,550||$0 to $14,650|
|12%||$10,275 to $41,775||$20,550 to $83,550||$14,650 to $55,900|
|22%||$41,775 to $89,075||$83,550 to $178,150||$55,900 to $89,050|
|24%||$89,075 to $170,050||$178,150 to $340,100||$89,050 to $170,050|
|32%||$170,050 to $215,950||$340,100 to $431,900||$170,050 to $215,950|
|35%||$215,950 to $539,900||$431,900 to $647,850||$215,950 to $539,900|
|37%||$539,900 or more||$647,850 or more||$539,900 or more|
As you can see by this table, if your income is $175k, and you are married filing jointly, your highest marginal rate is 22%. However, once you transition to a single tax payer, your highest marginal bracket is 32%! Additionally, you will lose half of the normal standard deduction you would have otherwise received when you filed a joint return. Of course, Social Security income will go down, but the RMD will likely be in the same ballpark. In addition, studies have shown that expenses don’t drop by 50% when you lose a spouse. Therefore, your income needs might be close to what they were before your spouse passed away. For these reasons, helping mitigate the tax impact of those RMDs or IRA distributions from a tax standpoint, when the surviving spouse switches to a single tax payer, could save thousands over a remaining life expectancy.
Reason #6: Enhancing wealth to the next generation
I talked about the SECURE Act in my article the tax trap of traditional 401ks and IRAs. I outlined how the Traditional 401k and Traditional IRA plans are some of the most unfavorable assets to leave to the next generation from a tax standpoint. This is because of the 10-year rule, which replaced the stretch IRA for most non spousal beneficiaries. Under the stretch IRA (old rule), your children could inherit your IRA and convert the RMD to their life expectancy, substantially reducing the amount required to be withdrawn, hence the term stretch IRA. With the 10-year rule now in effect, all of the funds in qualified retirement plans must be withdrawn within 10 years, assuming the beneficiary is not your spouse or other “qualified beneficiary.” Because of this change, the majority of beneficiaries will experience a forced spend down and an acceleration of taxes for those 10 years.
Consider what kind of tax bracket your beneficiaries are in. Are your children in a higher tax bracket than you are? Will this income put them in an unfavorable tax situation? Is maximizing legacy assets and minimizing what goes to Uncle Sam a priority? Roth IRA’s and Roth 401ks are still subject to the 10-year rule. However, those distributions will be tax free to your heirs. Furthermore, there is no annual minimum required distribution. Therefore, your beneficiaries could elect to keep the funds within the tax free account and withdrawal the entire balance in the last year, and they would have enjoyed an additional 10 years of tax free growth!
As you can see, there are many reasons to take advantage of Roth conversions as well as make Roth contributions if you want to maximize tax efficiency in retirement. However, this doesn’t mean you should blindly convert all of your retirement accounts to Roth, as the tax drag you might experience today could negate the long term benefits. It’s important to have a plan. For example, you might have a goal to fill up a certain tax bracket each year, let’s say 24%, with Roth conversions. Additionally, you might do this over the course of 5 or 10 years to get the biggest bang for your buck. Also, make sure you have a plan for how you will pay the taxes. If you don’t have surplus savings or assets to liquidate and pay the tax, it might preclude you from being a viable Roth conversion candidate. Furthermore, you might be in one of the highest marginal tax brackets already, and converting assets now doesn’t make sense given you might expect your tax bracket to drop in retirement. This might also make you a better candidate for deductible 401k contributions instead of Roth contributions. And finally, how do state income taxes compare now relative to where you might live in the future? If you live in New York with a state income tax, and expect to move to Florida with no state income tax, that could be a compelling argument for deductible contributions and deferring the taxes until you claim Florida as your primary domicile. There are many factors to consider before pulling the trigger on this strategy, so be sure to consult with your trusted advisor(s) before making any changes.