The Tax Cuts and Jobs Act (TCJA) of 2017 introduced significant changes to the U.S. tax code, many of which have profound implications for retirement planning. One notable area of impact is the increased attractiveness of Roth IRA conversions. Understanding these changes can help you make informed decisions to maximize retirement savings.
Let’s explore how the TCJA affects Roth conversions, why this strategy may be beneficial, and the key considerations for making the most of these tax law changes.
Understand Roth IRA conversions
A Roth IRA conversion involves transferring funds from a traditional IRA or 401(k) into a Roth IRA. While this process requires paying taxes on the converted amount in the year of conversion, it offers the benefit of tax-free growth and withdrawals during retirement.
Key changes under the TCJA
The TCJA brought about several modifications that enhanced the appeal of Roth conversions. One of the most significant changes was the reduction of federal income tax rates across various brackets. These lowered rates reduced the tax liability of a Roth IRA conversion.
The current tax rates will remain in effect until the end of 2025, creating a limited window of opportunity for tax-efficient conversions.
Unless new legislation is passed, individual tax brackets are scheduled to revert to their pre-TCJA levels in 2026. This would mean higher marginal tax rates for many taxpayers, particularly those in the middle-income and higher-income brackets. Evaluating the potential impact of these changes can help determine whether completing a Roth conversion before 2026 is advantageous.
Another crucial change was the elimination of recharacterizations. Before the TCJA, individuals who converted to a Roth IRA could reverse the conversion through recharacterization. The TCJA eliminated the ability to recharacterize Roth conversions, making conversions permanent.
The ability to recharacterize annual IRA contributions remains intact. This means you can change a contribution to a traditional IRA into a contribution to a Roth IRA (or the reverse) as needed. However, once you convert a traditional IRA to a Roth IRA, that conversion is permanent and cannot be undone.
Advantages of Roth Conversions
Lower tax rates make Roth conversions more attractive, but the benefits extend beyond the immediate tax savings. One significant advantage is tax-free growth and withdrawals. By paying taxes at today’s lower rates, your investments can grow tax-free within the Roth IRA.
Another key benefit is the absence of required minimum distributions (RMDs). Unlike traditional IRAs, Roth IRAs do not require account holders to take RMDs during their lifetime. This allows investments to continue growing tax-free for a more extended period, offering greater flexibility in retirement planning.
Roth IRAs also provide estate planning advantages.
The Secure Act of 2019 requires most non-spouse beneficiaries of Roth IRAs to withdraw the entire account balance within 10 years of the original owner’s death. While withdrawals remain tax-free, beneficiaries lose the ability to stretch tax-free growth over their lifetime, as was previously allowed.
However, surviving spouses, minor children (until adulthood), and certain disabled individuals may still qualify for exceptions allowing more extended distribution periods.
While withdrawals remain tax-free, this limits the ability to stretch tax-free growth over multiple decades, as was previously possible.
Considerations before converting
While the benefits of Roth conversions are compelling, you’ll need to evaluate several factors before proceeding.
One important consideration is your current and future tax brackets. If you expect to be in a significantly lower tax bracket in retirement, paying taxes now on a conversion may not be advantageous. Conversely, converting at today’s lower rates can be beneficial if tax rates rise or your income increases.
Another factor is your ability to pay the taxes on the conversion. The tax liability from converting a traditional IRA to a Roth IRA must be paid in the year of conversion. It’s best to use non-retirement funds to cover these taxes because using retirement assets to pay taxes can diminish the benefits of the conversion.
If paying taxes from a taxable account would require selling investments and triggering capital gains taxes, weigh the overall tax impact. In some cases, a partial conversion may help balance these trade-offs.
To cover conversion taxes from selling taxable investments, consider using tax-loss harvesting to offset gains or spreading sales over multiple years to minimize capital gains taxes.
It is also important to consider the impact of a Roth conversion on Medicare premiums and Social Security taxation. A higher taxable income from a Roth conversion could temporarily increase Medicare premiums and subject more of your Social Security benefits to taxation.
Medicare premium adjustments (IRMAA surcharges) use a two-year lookback period based on modified adjusted gross income (MAGI).
For example, a Roth conversion in 2023 would impact Medicare premiums in 2025.
For 2025, IRMAA surcharges apply if modified adjusted gross income (MAGI) exceeds $106,000 for single filers and $212,000 for joint filers (amounts adjusted annually).
Since crossing into a higher IRMAA bracket can significantly increase premiums, planning conversions to stay within lower thresholds can help manage overall costs. Consulting with a financial advisor or tax professional (or a financial advisor who is also a certified public accountant) can help assess these implications.
Strategies for implementing Roth conversions
Several strategies can be employed to optimize the benefits of a Roth conversion. One effective approach is executing partial conversions over several years rather than converting the entire balance at once. This strategy helps manage your tax bracket, minimizing the immediate tax impact and spreading the tax liability over multiple years.
The timing of conversions is another key consideration. The period between retirement and the start of required minimum distributions can be ideal for conversions. During this window, your income may be lower, allowing you to convert funds at a lower tax rate.
While converting during a market downturn can reduce the taxable amount of the conversion, it’s important to avoid attempting to time market movements. Instead, focus on aligning conversions with your broader tax strategy, spreading them over multiple years if needed to manage tax brackets effectively.
Final thoughts
The Tax Cuts and Jobs Act has created a favorable environment for Roth IRA conversions, but this opportunity is time sensitive. The current tax rates expire at the end of 2025, making now an ideal time to evaluate whether a conversion aligns with your retirement goals.
Lower tax rates, eliminating recharacterizations, and the long-term benefits of tax-free growth make Roth conversions attractive for many.
Disclaimer: Content in this material is for general information only and is not intended to provide specific financial, tax, or legal advice. All investing involves risk, including loss of principal. No strategy ensures success or protects against loss. Always consult a qualified financial professional before making investment or tax decisions.