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Bracket Bumping and Roth Conversions

Bracket Bumping and Roth Conversions

July 05, 2022

A Roth IRA conversion involves the transfer of retirement assets from a traditional IRA or 401k into a Roth IRA. You would pay income tax on the money that you convert, but you will be eligible to make tax-free withdrawals from the account in the future. To make sure that the withdrawals of earnings are tax free, you will want to make sure that 5 years has passed since the conversion and that you are age 59 and a half or older.

In order to see if a Roth conversion makes sense for you, we first have to look at your Adjusted Gross Income and where this lands you in the federal income tax brackets. Please see the chart below for reference.

The major reason to do a Roth conversion is if you expect your current tax bracket to be lower now, than in the future. We like to think of the 10% and 12% brackets as being the greatest areas of opportunity to maximize, but there are others. This is because it is a 10% jump into the next bracket at 22%!  You can maximize these lower brackets through making strategic Roth conversions from your pre-tax accounts like IRAs.

Your tax bracket may be higher in the future for a few reasons. First of all, there is no predicting what the tax brackets and tax rates will be in the future but many expect that these will rise. Especially with the large deficit and the Tax Cuts and Jobs Act set to sunset at the end of 2025.

Additionally, you can see your tax rate increase when you have to start taking distributions from your IRAs and/or 401ks at 72. If you make a Roth conversion, this will also reduce the amount you have to take out at that time because your pre-tax account values will be lower!

Another huge thing to consider is the tax brackets for those that are married versus those that are single. Many times, widows will be receiving less income but will be pushed up to higher tax brackets when their spouse passes away. In addition to higher tax rates, widows lose about half the standard deduction as a single filer, driving their tax bill higher. Therefore, a Roth conversion may be a good estate planning technique for your spouse.

Lastly, a Roth conversion may help your non-spouse beneficiaries as well. Your IRA originally reduced your taxable income but when you go to take income out, this will be taxed at your current tax level. When your spouse inherits an IRA, they will take it on as their own but when a non-spouse inherits an IRA, they will have to liquidate it in 10 years and pay the taxes when they make the distribution at their tax-level. This often happens at their highest earning years and can have a huge tax implication! Therefore, it may be beneficial to think about a Roth conversion if leaving a legacy is one of your priorities.

As Benjamin Franklin is known for saying “…nothing is certain except death and taxes.” This all boils down to whether it makes sense to pay the taxes now or later. Please reach out to your financial planner and tax advisor to see if this strategy makes sense for you!