With tax changes on the horizon, is now the time for a Roth conversion?

By Alessandra Malito

Tax rates are sunsetting next year, so it may be time to get in on low rates.

With tax rates sunsetting in a little more than a year and the rules changing for inheriting retirement accounts, now may be a good time to consider a Roth conversion.

The current tax brackets, which were set under the Tax Cuts and Jobs Act passed during the Trump Administration, will expire on Dec. 31, 2025, at which point the rates will revert to the higher levels in place prior to the law. How a beneficiary inherits a retirement account is also in the midst of its own changes. The IRS recently issued final guidance on required minimum distributions for inherited accounts, and a Roth IRA is one option for getting money into a favorable tax situation.

With Roth accounts promising tax-free distributions in retirement (if a person follows all of the rules related to contributions and conversions), now seems like as good a time as any to convert money from a traditional IRA to a Roth account. The problem? Conversions cost money - and depending on how much is transferred, it could cost a lot of money.

Retirement savers, who tend to be focused on accumulating money in their investment accounts to build their nest eggs and take advantage of compounding, are often hesitant to do Roth conversions because of the tax bill they'll have to pay in the present, compared to the taxes they would pay at the time of distribution in retirement, experts say.

Some professionals, such as Ed Slott, a certified public accountant, argue Roth accounts are the best type of account, even if you have to pay the taxes at the front end. "I have an 'always' rule because it's always true - always pay taxes at the lowest rates. It is very simple. Nobody likes paying taxes up front so they let it go," he told MarketWatch during a conversation about his latest book, "The Retirement Savings Time Bomb Ticks Louder."

There's no way to know for sure what tax rates will be like in retirement, especially when that chapter in life could be decades away. Factors will vary, including how the government has set the tax brackets at the time of retirement and through the course of one's career; retirement income needs and expenses, which may fluctuate; as well as longevity, which will affect how long a person will actually withdraw their assets.

Still, there are a few questions to answer and number-crunching exercises retirement savers can take if they're interested in converting money from traditional accounts over to a Roth.

The first thing is understanding the current tax rate you're in and how it will fluctuate over time up until distribution.

"The simplest test of whether a Roth conversion makes sense is a comparison of the two marginal tax rates: the one at which the Roth conversion is done versus the rate when the funds would otherwise be withdrawn from the IRA," said George Gagliardi, a certified financial planner and founder of Coromandel Wealth Strategies. "This is also the reason that in 2024 and 2025, while the 2017 Tax Cuts and Jobs Act is still in effect, Roth conversions are easier to do with the reduced tax rates and widened tax brackets. It is anyone's guess what future tax rates will be, but if I were pushed to make a choice, 'higher' seems the likeliest scenario."

The next important question retirement savers can ask themselves is whether they can pay the tax bill without using any of the money being transferred. "It is important that you do not cannibalize your Roth IRA conversion," said Byrke Sestok, a certified financial planner and president of Rightirement Wealth Partners. "Let's say you convert $20,000. That whole $20,000 should go directly to your Roth IRA and then at tax time the taxes should be paid from regular savings. This also means you should be planning well in advance of retirement for Roth IRA conversions. You need to have regular savings and investments accumulated to pay the conversion taxes."

By paying the taxes outside of the converted assets, the full amount converted can continue to grow in the Roth account tax-free, as opposed to the balance dipping to compensate for the tax bill. A lower balance would potentially result in lower returns, because there's not as much money to reap the benefits of compound interest.

Paying the tax liability without touching the account balance isn't always possible, and some experts say it shouldn't be the determining factor to move forward with the conversion. "It's natural to assume that having a larger balance in IRA account may be the better option, but keep in mind that as the value of the IRA grows, the tax liability increases as well," Carl Holubowich, a certified financial planner and principal of Armstrong, Fleming & Moore. "If you don't factor in taxes, you might not realize that having a smaller balance in a Roth IRA might still be the better option."

Holubowich gave an example: Assume you have an IRA with $100,000 and a taxable investment account with $25,000. They both double in value in 10 years, at which point they're worth $250,000. If the IRA were converted to a Roth and the taxable account was used to pay the tax bill (assuming a rate of 25%), that saver would only have $200,000 in the Roth after a decade, but if that person still had a 25% tax rate, the value of the IRA without moving the money over would have an after-tax value of $150,000, and the taxable account, which may have gained $25,000 and might be taxed at a lower rate because of long-term capital gains, will come out after-tax at $46,250. "You wind up with $200,000 in a tax-free Roth IRA or $196,250 combined between the IRA and taxable account," Holubowich said. "The difference might seem not worth the hassle, but the Roth IRA gives you a lot more flexibility since there are no annual required minimum distributions and taking withdrawals won't trigger higher Medicare premiums in retirement."

Another question to ask before making the move is the gap between the saver's current income and the top of his marginal tax bracket, said Margo Dover, a certified financial planner at J. Mark Nickell & Co. "For example, if their estimated income is $150,000, then there is a gap of $51,050 to the top of the 22% marginal tax bracket for married, filing jointly. That gap could be filled with a $50,000 Roth conversion," she said.

For some high-earning investors, the best time to do the conversions may be in the first few years of retirement, Dover said, when their income has dropped but they aren't yet taking Social Security.

Pinpointing an exact number may not be possible, but considering all of the factors that affect retirement income and tax liabilities, as well as running a few scenarios when making estimates, can help people make the most sense of how much money, if any, should be converted to a Roth account.

"There is no simple calculation to determine the break even point to determine if a Roth conversion makes sense," said Stephen Maggard, a certified financial planner at Abacus Planning Group. "And I would add that if you owe no taxes during retirement, you probably did it wrong and paid too much on the front end. The goal should be as little taxes over your lifetime."

-Alessandra Malito

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09-07-24 0942ET

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