Physician Retirement Planning

The Closing Window Of Opportunity For Roth IRA Conversions

The best time to do a Roth conversion is in the next 4 years. There are two situations when contributing to a Roth IRA is particularly advantageous: when the stock market plummets and when income tax rates are low. In 2016, Congress voted to reduce income taxes, beginning in tax year 2017. Without additional legislation, those tax reductions will expire in 2025. Given historical precedent and the amount of Federal spending that has occurred in the past 2 years in combating COVID and in infrastructure spending, it seems likely that income tax rates will return to the 2016 levels in 2025. That means that we have 4 years  left to take advantage of some of the lowest income tax rates in recent memory. It also means that we have 4 years left to take advantage of lower-cost Roth IRA conversions.

To understand why Roth conversions are going to be less expensive now than in 2025, you first have to understand how income taxes work. In a previous post, I discussed the differences between income tax brackets and effective marginal income tax rates. The bottom line is that we place way too much emphasis on the tax brackets. What we actually pay in income tax depends on the effective tax rate and not the bracket. The effective tax rate goes slowly and steadily up for every additional dollar we earn. The income tax brackets simply determine the slope and position of the curve of the effective tax rates. In the graph to the right, you can see last year’s income tax brackets in the dotted line but the actual income tax rate a person pays is always less than the bracket that they are in, as shown in the solid line.

When congress voted to reduce the tax brackets beginning in 2017, the effect was to shift the curve of the graph downward so that everyone at all income levels paid lower effective income tax rates. Depending on one’s taxable income, the effective tax rate dropped by 3.5 to 6.0 percentage points. The graph on the right illustrates the difference in the effective tax rate for annual taxable incomes between $40,000 and $700,000 for 2016 (before the tax cuts) and 2020 (after the tax cuts). For example, a family with a taxable income of $250,000 per year had an effective income tax rate of 21.5% in 2016 but that dropped by 4.6 percentage points to an effective income tax rate of 16.9% in 2020. Looked at in a different way, that family paid $53,750 in federal income tax in 2016 but only paid $42,250 in 2020.

So, what do lower income taxes mean for Roth conversions?

Roth IRAs have two important advantages over other retirement savings accounts: (1) you do not have to pay taxes when you take money out of the Roth account and (2) you do not have to take required minimum distributions at age 72 like you do with a 401k or other deferred income accounts. There are two ways that you can contribute to a Roth IRA: direct contribution and conversion contribution. If you are married filing jointly, then you can annually contribute up to $6,000 ($7,000 if over age 50) directly to a Roth IRA if you make less than $198,000 (you can do a partial contribution if you make between $198,000 and $208,000). If your income is over $208,000, then you cannot contribute directly to a Roth. However, you can do a Roth conversion by first contributing to a traditional IRA and then converting those funds into a Roth IRA within 60 days. This sometimes called a backdoor Roth approach.

It is easiest to do a Roth IRA conversion from a traditional IRA, especially if both the traditional and Roth IRAs are in the same investment company. It is also possible to convert funds from a 401(k), 403(b), or 457 plan into a Roth IRA but it can be more complicated. You generally must be over age 59 1/2 and also no longer employed by the employer that sponsored the 401(k), 403(b), or 457 plan. Also, the administrator of the 401(k), 403(b), or 457 plan may not permit you to convert funds directly into a Roth IRA and so you may have to first rollover funds from the 401(k), 403(b), or 457 plan into a traditional IRA and then convert the traditional IRA into the Roth IRA within 60 days. Of critical importance is that when you convert funds from a tax-deferred account (such as a 401(k), 403(b), or 457 plan) into a Roth IRA, that money is subject to regular income tax the year that you do the conversion. This means that not only do you have to pay income tax on the value of the conversion, but the amount converted adds to your total taxable income so it will push you up to a higher income tax rate the year that you do the conversion. The extra steps involved in doing this type of conversion can be a headache; however, as we will see, it can be worth it from a tax savings standpoint.

Although I personally think that everyone should have a Roth IRA as component of a diversified retirement portfolio, there are 2 situations when it is especially advantageous to do a Roth conversion: (1) when there is a significant drop in the stock market and (2) when your income tax rate is lower now than it will be when you are retired.

  • When the stock market falls. If you already have money in a traditional IRA, then the best time to convert that money into a Roth is when the value of the IRA is at the lowest (and therefore you pay the least amount in income taxes). The best example of this in recent years was in March 2020 when the S&P 500 index fell by 32% as a consequence of the COVID pandemic. If you had $1,000 in a stock index mutual fund traditional IRA on February 10, 2020, then it was only worth $680 on March 16, 2020. However, by August 2020, the stock market had completely recovered back to its January 2020 value. If your effective tax rate was 16.8%, then you would have paid $168 in taxes to do a Roth conversion of the total amount of the traditional IRA in February but only $114 in taxes to do the conversion in March. If you are older than 59 1/2 and retired, then you could also have done a Roth IRA conversion from a 401(k), 403(b), or 457 account. The stock market inevitably goes up, goes down, and then goes back up again. Take advantage of the drops in the stock market to do the Roth conversions – that way, when the stock market rises in the future, the recovery in value of your investment will all be tax-free. How much does the stock market need to drop to trigger a Roth conversion? That is a matter of opinion but a 20% drop is a reasonable trigger.
  • When your income tax rate is lower. For most people, income tax rates will be lowest when they first start out in the work force and their taxable income is relatively low. Their income tax rates will be highest in the years just before retirement when they are in their peak earning years. In retirement, their income tax rate will usually fall to a rate somewhere in-between their lowest and highest income earning years while working. Therefore, for most people, the best time to do a Roth conversion is early in their careers, when their taxable income (and thus their income tax rate) is still relatively low. However, the other time that a Roth conversion is advantageous is when everyone’s income tax rates are low but will go up in the near future.

History tells us that tax rates, like the stock market, periodically go up and periodically go down, as illustrated in the graph to the right. The problem is that no one can predict with certainty exactly when tax rates will go up or down. Federal income tax rates are low now so it is highly likely that they will go up in the future. The current lower tax rates are set to expire in 2025 at which time they will revert to the higher 2016 rates (unless congress votes to extend them). Which political party is in charge of congress and the White House will have a big impact on whether taxes will go back up in 2025 (as planned) or stay low (requiring additional legislation). However, unless there is a significant reduction in federal spending in the next 4 years, then it is likely that there will be no alternative to letting the tax rates go back up in 2025.

Therefore, if your income remains relatively constant, it will cost you less to do a Roth conversion now than it will cost beginning in 2025. As an example, in 2021, a person making $200,000 has a federal income tax rate of 15% but in 2025, a person making $200,000 will have a 20% income tax rate. So, by doing a $50,000 Roth IRA conversion in 2021 (and thus increasing their taxable income to a total of $250,000), this person would pay a total of $42,250 in income tax but if they wait to do the Roth IRA conversion in 2025, this person would pay a total of $53,750 in income tax. In other words, as shown in the calculation below, this person will pay $11,500 more in income tax to do a Roth conversion in 2025 than in 2021:

In fact, a person would need to make $380,000 per year in 2021 to be taxed at the same rate that an income of $200,000 will likely be taxed in 2025. Therefore, a person making an annual income of $200,000 in 2021 can convert an additional $180,000 into a Roth IRA this year and still pay the same income tax rate that they will pay on an income of $200,000 (with no Roth conversion) in 2025.

Know the rules about Roth Conversions

The tax laws regarding Roth IRA withdrawals are complicated and depend on your age, how long ago you opened the Roth IRA, whether you are withdrawing the contribution (amount you originally put in) versus earnings (amount you made off of the contributions), and whether the contribution was a direct contribution or a conversion contribution. For direct contributions (eligible for couples filing jointly with an income of < $198,000), you can take money out of the Roth contributions anytime but you cannot take money out of the Roth earnings until you have had the Roth account open for at least 5 years and you are at least 59 1/2 years old. For conversion contributions, the conversion must have occurred at least 5 years previously, regardless of your age, before you can withdraw the contributions from the Roth account. The IRS uses a “first in, first out” rule when tracking the conversions so that every conversion amount that you make to a Roth IRA has its own 5-year requirement before you can withdraw it. In other words, consider the amount of each Roth IRA conversion to be locked up for 5 years.

Roth IRAs are not subject to required minimum distributions, unlike other deferred compensation accounts (such as traditional IRAs, 401(k)s, 403(b)s, and 457s). Required minimum distributions are a certain percentage of the deferred compensation accounts that the IRS requires you to withdraw each year after age 72. If a person has a lot of money in these deferred compensation accounts at age 72, this can result in taxable income high enough to push the person’s effective income tax rate up. Therefore most retirees will start to preferentially draw down their traditional IRAs, 401(k)s, 403(b)s, and 457s before age 72 and hold off on taking withdrawals from their Roth IRAs until after age 72 in order to maintain the lowest income tax rates during their retirement years. In general, you cannot convert required minimum distributions into a Roth IRA.

Now is the time to do a Roth conversion

If the 2016 tax cuts are left to expire in 2025, then there will be 4 more years of lower income taxes before income tax rates go back up. Therefore, it will cost you less to do a Roth IRA conversion in 2021, 2022, 2023, and 2024 than it will to do a Roth conversion in 2025 and later. The best Roth strategy depends on a person’s age:

If you are younger than 59 1/2: Do a direct Roth IRA contribution if your income is less than $198,000 (married filling jointly). If your income is higher, then you can make a contribution to a traditional IRA (up to $6,000 per person under age 50 and $7,000 per person over age 50) and then promptly convert the traditional IRA contribution into a Roth IRA (backdoor Roth). A common question that comes up is whether it is better to contribute to a deferred income account such as a 401(k)/403(b)/457 (pre-tax dollars) or better to contribute to a traditional IRA and do a backdoor Roth conversion (post-tax dollars). If your employer offers a matching contribution to your 401(k)/403(b)/457, then it is always better to contribute to the 401(k)/403(b)/457. There are two situations when doing a backdoor Roth is advantageous:

    • You have already contributed the maximum to your 401(k)/403(b)/457 and you have some additional post-tax money that you want to invest for retirement. In this situation, if you put the money into a regular investment, you will eventually pay capital gains tax on the earnings but if you put the money into a backdoor Roth, you pay no taxes on the earnings.
    • You believe that you will have a higher income tax rate in your retirement years than your current tax rate. Remember, however, that by contributing to a 401(k)/403(b)/457, you are lowering your taxable income for the contribution year and thus lowering your tax rate that year. Conversely, your income tax rate will be higher if you do not contribute to your 401(k)/403(b)/457 and do the backdoor Roth instead. Nevertheless, for the next 4 years, if you do not have a lot of extra cash on hand in your checking account, you may be better off to reduce your 401(k)/403(b)/457 contributions by enough to give you $6,000 after-tax ($7,000 if over age 50) and then put that $6,000 into a traditional IRA followed by a backdoor Roth conversion.

If you are between 59 1/2 and 67: You can do a direct contribution (if your income is low enough) or a backdoor Roth. But you should also consider converting a portion of your traditional IRA, 401(k), 403(b), or 457 into a Roth IRA. The optimal amount to convert will depend on how much higher you project your taxable income will be in 2025 than it is in 2021. If your taxable income is going to be about the same, then you may be able to convert up to $100,000 – $150,000 and still come out ahead from a tax standpoint. If you project that your income will be higher in 2025 than it is now (and thus have an even higher income tax rate), then you can convert more than $100,000 – $150,000. If you project that your income will be lower in 2025 than it is now, then it still may be advantageous to do a conversion now but the conversion amount should be less. If you are still working, you can do a Roth conversion from your traditional IRA but you probably will have to wait until retirement to do a Roth conversion from an employer-sponsored 401(k), 403(b), or 457 (withdrawals from these accounts while still working are usually not permitted). Importantly, remember that you will pay income tax on the amount of the conversion so you should only do the conversion if you have sufficient cash on hand to pay that extra tax.

If you are between 67 and 72: Things get a bit more complicated. Remember, each conversion contribution needs to be in your Roth account for at least 5 years in order to avoid an early withdrawal penalty. So, if you plan to start taking money out of your Roth at age 72, then the year you turn 72, you should only take an amount equal to the conversions that you did before age 67 to avoid paying the IRS penalty. This means that you have to track your Roth conversions and have a record of how much you converted each year. It may still be advantageous for you to do Roth IRA conversions between ages 67 and 72 but you should be sure that you do not plan on withdrawing those annual conversions from your Roth IRA for at least 5 years.

If you are older than 72: Doing a Roth conversion after age 72 is usually unwise. Because required minimum distributions from deferred compensation accounts are necessary starting at age 72, taking additional money out of these accounts to do Roth conversions will result in more taxable income and thus push the income tax rate up higher. Some people who are still working and contributing to a 401(k)/403(b)/457 after age 72 may be exempt from required minimum distributions and thus be in a position where a Roth conversion is still advantageous but they should check with a tax advisor because this is a very complicated area.

It’s all about the math

If the current tax rates expire in 2025 and revert to the 2016 rates as anticipated, then there is a 4-year window of opportunity for Roth conversions in order to take advantage of the lower tax rates. A carefully timed Roth conversion can save you money by reducing the total amount of income tax you pay over your lifetime. But you have to be strategic with your timing or you could end up paying more in income taxes. If you are not sure, then get help from a tax expert.

September 7, 2021

By James Allen, MD

I am a Professor Emeritus of Internal Medicine at the Ohio State University and former Medical Director of Ohio State University East Hospital