The wisdom of Roth conversions depends on your household’s circumstances
Dear Dan,
Now that Donald Trump is back in office, it looks like tax rates won’t go up. Does this make Roth conversions from an IRA less attractive?
Taxed in Tuscaloosa
Dear Taxed,
The wisdom of undertaking Roth conversions is highly dependent on the particular household circumstances. Roth conversions do not avoid taxes, they accelerate taxes. Conversions pay off when the tax rate paid on the converted amounts is lower than the tax rate the funds would pay in the future.
So if you are currently in a high tax bracket and are planning on leaving your IRA to a beneficiary in a low tax bracket or a charity in a zero tax bracket, Roth conversions were not a great choice before the election and remain a poor choice after the election.
On the other hand, the election certainly means that it is very likely that many of the tax code changes made early in Trump’s first term will not expire as scheduled. If you are in a low bracket now anticipating higher rates down the road, an extension of the low rates may or may not make a difference.
Tax law changes could very well be a cause of higher rates in the future but there are other things that can cause higher rates to apply even if the tax code is never changed from what we have now. I’ll give you two examples. Neither is certain, but one or both applies to many households.
The first is often called the “widow’s penalty” or “survivor’s penalty.” The term applies to married filers and can manifest because the tax rates applicable to the same taxable income are higher for singles than couples filing a joint return. Taxable income is what remains after accounting for deductions and adjustments to the total income received by the household. Note that the standard deduction for a single filer is half that of a married couple.
The condensed single-filer tax brackets can lead to a greater income tax liability, hence the term “widow’s penalty.” For instance, in 2025, the 22% tax bracket starts at $96,951 of taxable income for a married couple filing a joint return. However, the 22% tax bracket kicks in at $48,476 for a single filer. Because a surviving spouse can treat an inherited Roth IRA as their own Roth IRA, the surviving spouse will not be subject to Required Minimum Distributions, or RMDs, from the Roth IRA and any distributions taken voluntarily will not be added to taxable income.
The second way a higher rate can apply in the future is the 10-year rule for inheriting retirement accounts and IRAs. Your beneficiary may be in a lower tax bracket now but if they were to inherit your IRA and no exception applies, they must take all the funds out of the applicable account by the end of the 10th year after your death.
Inheriting a large enough IRA can result in pushing the beneficiary into a higher bracket, even if the withdrawals are spread out over the ensuing 10 years after your death (there can be RMD in years 1-9).
For instance, say your IRA is worth $1 million today. If your beneficiary spreads out withdrawals over 10 years by distributing $100,000 per year, that $100,000 of additional income can push your heir in a higher bracket. If the account earns anything over that decade, the taxable income would be even higher. An Inherited Roth IRA is also subject to the 10 year rule but no RMD in year 1-9 is needed and distributions from the Roth IRA at any point are unlikely to generate taxable income.
The 10-year rule can affect you directly as well if you inherit an IRA or retirement account such as a 401(k) from someone other than your spouse. Add income from inheriting such an account to your income, especially if you are of RMD age during the 10-year period, and those funds could cause you to jump up into a higher bracket. By converting your IRA to a Roth IRA, your Roth IRA is not subject to RMD and therefore not adding to your taxable income.
Bottom line: Roth conversions may still be wise even if tax legislation doesn’t result in tax rate increases in the near future.
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Originally published on MarketWatch. Read the original article here.