Broker Check

Bracket Bumping and Roth Conversions

August 22, 2023

The United States’ national debt is over $32 trillion dollars and many of our clients have expressed their concerns about higher tax rates in the near future. In this light, does moving money from pre-tax accounts, like an IRA, to post-tax accounts, like a Roth IRA, make sense? 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 now, but would be eligible for tax-free withdrawals from the account in the future. To make sure that the withdrawals of earnings are tax free, you must wait 5 years from the time of the conversion and be 59 and a half or older.

To see if a Roth conversion would be beneficial, you first want to look at your Adjusted Gross Income on your most recent tax return and see where this lands in the federal income tax brackets. Please see the chart below for reference. If you file a single tax return, your standard deduction and bracket thresholds are on the left and married is on the right.

A major benefit 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. This is because it is a 10% jump into the next bracket at 22%! 

Your tax bracket may be higher in the future for a few reasons. The first being: The Tax Cuts and Jobs Act of 2017 made a number of changes to the tax code. With the most notable being the lowering of tax rates for individuals and corporations. However, these changes are set to expire at the end of 2025, which means that tax rates will likely go up at that time if Congress doesn’t take action to extend or revise the law before then. This means that individual tax rates could go back up to pre-2018 levels. This can be seen by the graphic below that shows both higher tax rates and lower income thresholds to reach the next bracket.

Additionally, your tax rate can increase when you have to start taking distributions from your IRAs and/or 401ks at 73 or 75 depending on your age. These required minimum distributions must be taken by April 1 of the year that you turn 73, and by December 31 each following year. Then, starting in 2033, SECURE 2.0 again pushes the age at which RMDs must start to 75.

Another variable 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. When your spouse inherits an IRA, they will take it on as their own. However, when a non-spouse inherits an IRA, they will have to liquidate it within 10 years and pay the taxes, at their tax-level, when they make a distribution. 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!