Why You Should Consider a Roth Conversion in 2024 and 2025

Roth conversions are like home renovations: Causing some destruction and raising costs temporarily, to create something of more lasting value. Photo by Milivoj Kuhar on Unsplash

At Hale Financial, we know many Wyoming retirees who would love to see their tax bill go down year after year. It may seem odd to you, then, that we plan to talk with many of our clients about paying more in taxes this year and next year through a process called a Roth conversion.

Why would we intentionally raise our clients’ tax bills? Have we gone mad?! In this article we’ll review the benefits of Roth conversions, with some focus on why they can make so much sense in 2024 and 2025.

What is a Roth Conversion?

A Roth conversion is when you withdraw funds from a tax-deferred account like a Rollover IRA or company retirement plan, but instead of sticking those dollars into your bank account, you put them into a Roth IRA. These withdrawals are taxable. There is no limit to the amount of money you can Roth convert, but the more you convert, the more tax dollars you pay. So why do it?

Roth conversions create tax diversity

Most investors understand the benefit of Roth IRA dollars. You receive tax-free growth, and when you withdraw the funds from your Roth IRA, they come out tax-free. 

The benefit of accessible tax-free funds should not be ignored. Consider a retired couple who lives on Social Security, a government pension, and has $500,000 in a Rollover IRA. They live comfortably year to year on this income. One year, however, they discover their roof has been leaking into their home behind a wall, causing an unseen mold issue. Insurance won’t cover it, but the mold needs to be removed and the roof repaired, resulting in a $40,000 bill.

What are their options? They can take out a loan, but this couple would rather avoid debt during retirement if they can, especially at today’s high interest rates. Their next best bet is a withdrawal from their Rollover IRA. The problem is, that $40,000 withdrawal is all taxable. If their taxable income for the year is $80,000, then about $13,000 of the withdrawal will be taxed at 12%, but the remaining $27,000 will be taxed at 22%...for a total tax bill of $7,500.

If this couple had Roth dollars, they could withdraw the funds for this much needed repair tax free.

Roth conversions take advantage of historically low tax rates

The chart below illustrates the highest marginal individual tax rates over the last 100+ years in the US. Only the highest income Americans pay taxes at these rates, but the chart summarizes a general fact: tax rates in the past were higher than they are today. Most clients we work with at Hale Financial have a marginal tax rate of 12% to 24%.

If you’re at a historically low tax rate today, it can make sense to take advantage of that opportunity by intentionally paying more taxes today, rather than waiting to pay taxes later if or when tax rates rise. Roth conversions acknowledge this opportunity by paying the tax bill now, in exchange for tax-free growth and withdrawals in the future.

If the retired couple in the earlier example was regularly in the 12% marginal tax bracket, they could “fill up” that tax bracket with Roth conversions. 2024 and 2025 are prime opportunities to do so, since much of the current tax environment (such as lower marginal tax rates and a doubled standard deduction) is due to the Tax Cuts and Jobs Act of 2017, which has many provisions that go away at the end of 2025 unless they’re extended. Here’s an illustration of what their Roth conversion scenarios could look like:

Roth conversion are a great gifting/estate planning tool

Roth funds can be an incredible gift to your heirs as well. That’s because inherited Roth IRAs are not taxable when they pass to your heirs, and they can withdraw funds tax-free as well! Current IRS rules require non-spousal heirs (like children) to fully deplete inherited IRA accounts after 10 years, but this still gives you and them years and years of tax-free growth and tax-free withdrawals. 

The original Roth IRA account holder never has a required distribution, allowing these funds to grow tax-free for decades.

Roth conversions reduce required RMDs from your IRA

Eventually, all tax-deferred IRA accounts have what is called required minimum distributions, or RMDs. For most retirees these required withdrawals begin between ages 72 to 75. The amount of the RMD is based on the ending account balance in the previous year. Completing Roth conversions can help reduce the balance in tax-deferred IRA accounts.

A few Roth conversion precautions

Roth conversions are all about understanding where your income will be, so you can intentionally convert additional income (through IRA withdrawals) into Roth dollars. 

Know Your Income

This means you need to do the work to accurately estimate your income in the year you’re considering a Roth conversion. This means gathering your latest pay stubs, interest and dividend payments, Social Security or pension payments, and small business income projections. You’ll also need to factor in capital gains through asset sales (like stocks or real estate), and any withdrawals you’ve already made from tax-deferred retirement accounts. 

There is definitely some art to this, since you’ll never know precisely how much income you’ll make in a certain year until that year is through (and the Roth conversion deadline, December 31st, has passed). 

Pay the Tax Man On Time

When completing a Roth conversion, you’ll also need to have a source of funds to pay the taxes. Some figure they’ll withdraw extra funds from their IRA to cover these, but this usually adds to your tax bill in an unexpected way, since the funds withdrawn for the tax payment end up being taxable as well! It’s better to estimate how much in taxes you’ll owe from your Roth conversion, and pay the taxes from cash savings, checking, or a taxable investment account. These can be paid directly to the IRS at the time of conversion, which we highly recommend.

Know the Gotchas

Finally, there are multiple “gotchas” in the tax code that can pop up when your taxable income increases. For example, increased income can raise the amount of your Social Security that’s taxed. It can also increase your Medicare Part B insurance premiums, or expose you to the Net Investment Income Tax. And of course, converting too much to a Roth IRA can push some of your taxable income into a higher marginal tax rate. As a result, it’s usually best to consult with a tax advisor before completing a Roth conversion, or a financial professional with software that can analyze the tax implications.

Roth conversions are a great opportunity to convert tax-deferred dollars into tax-free dollars. The benefits to doing so abound, but precautions need to be taken. 2024 and 2025 are ideal years to consider this strategy, until the fate of the 2017 tax cuts is more sure.