Many taxpayers are benefiting from the lower income tax rates generated by The Tax Cut and Jobs Act of 2017. But, those tax rates are scheduled to expire at the end of 2025, and a newly elected Congress might end them even sooner. Is there a way for taxpayers to lock in today’s low income tax rates for income that they’ll receive in future years? Yes. It’s called a Roth individual retirement account conversion.
With a Roth IRA conversion, an individual withdraws assets from a traditional pre-tax IRA or qualified retirement plan (QRP) account and deposits the amounts into a Roth IRA, where the assets and all future investment income are exempt from federal and state income taxation. The conversion triggers an income tax liability,1 but taxpayers who are currently subject to lower than usual income tax rates are effectively locking in today’s low income tax rate for income that would have otherwise been taxed in the future. Anyone who has an IRA is eligible. Even individuals under age 591/2, who usually incur a 10% penalty on receipt of a taxable distribution from an IRA or a QRP account, can do a Roth IRA conversion without paying the 10% penalty.2
This tax-saving opportunity is most pronounced for married taxpayers with taxable income under $320,000 —an “income tax sweet spot.” Usually, a problem with doing a Roth IRA conversion during a client’s working years is that the taxable income from the Roth conversion, when added to other income, could push a taxpayer into a higher income tax bracket. Until 2018, married couples with taxable income between $240,000 and $320,000 had been subject to a 33% marginal tax rate on every dollar of income in that range. But, as Bruce D. Steiner pointed out in his 2018 article on this strategy,3 in 2019, those married couples are only subject to a 24% tax rate, a substantial discount. If they expect that their future retirement income will probably be taxed at rates greater than 24%, then it can make a lot of sense for them to convert some of their money from a traditional IRA into a Roth IRA in 2019. It would be best to use assets in a taxable account (for example, a brokerage account) to pay the tax liability. By paying the tax with such assets, a taxpayer is effectively moving future taxable interest, dividends and capital gains from the taxable brokerage account into the tax-exempt Roth IRA.
By comparison, the tax-saving opportunities from the tax rate changes don’t appear to be as generous for unmarried individuals. See “Marginal Income Tax Rates,” p. 31, for a comparison of 2019 and 2017 tax rates. Still, individuals may find opportunities that are unique to their particular circumstances when a Roth IRA conversion might make sense.
For wealthy taxpayers, a Roth IRA conversion is one of only two ways that they can get the benefits of a Roth account. High income taxpayers can’t contribute to a Roth IRA. In 2019, an individual’s ability to contribute up to $6,000 to a Roth IRA ($7,000 if over age 49) is restricted if his adjusted gross income (AGI) is over $120,000 ($193,000 on married joint returns), and any contribution is prohibited if AGI exceeds $135,000 ($203,000 on married joint returns).4 However, there’s no income limitation to do a Roth IRA conversion.5 The second way to get the advantage of a Roth account is to work for an employer who offers a Roth 401(k) plan, a Roth 403(b) plan or a Roth 457(b) plan, because there’s no income limit on contributing amounts to accounts in such plans. A traditional 401(k) account can’t be converted into a Roth 401(k) account; conversions may only be made into a Roth IRA.6
Opportunity for After-Tax Wealth
Which produces more after-tax wealth, a Roth IRA or a traditional IRA? The answer is: it depends on the tax rate in the year of contribution and the tax rate in the year of distribution. If those tax rates are the same, then the pre-tax income deposited into a traditional IRA will produce an identical amount of after-tax wealth in the year of distribution as a deposit of after-tax income into a Roth IRA.7 The corollary of this maxim is that a Roth IRA will be superior if an individual expects to be in a higher tax bracket in retirement, and a traditional IRA will be superior if an individual expects to be in a lower tax bracket in retirement. Ultimately, though, a Roth account offers the opportunity to hold more after-tax wealth in a tax-sheltered environment than a traditional account because it’s funded with after-tax dollars.8
When Conversion Makes Sense
Here are five situations:
1.A taxpayer expects income from retirement plan distributions to be subject to higher tax rates in future years either during retirement or after death.
Retirement:Future tax rates are speculative. But, even if clients expect that their income will decline during retirement, all married individuals should consider making a Roth IRA conversion to take advantage of low married joint rates. After one spouse dies, the surviving spouse will be subject to the higher marginal income tax rates that apply to unmarried individuals.
After death: In addition to the concerns about a surviving spouse, if retirement assets will be paid to a trust after death, then the income will likely be subject to the highest marginal income tax rate, because trusts pay the highest income tax rate with just $12,500 of income. A lifetime Roth IRA conversion will usually generate a lower income tax rate than trust tax rates. Also, a taxpayer may reside in a state that has no state income tax, but the children/beneficiaries live in states that have state income taxes, so the taxable distributions that they receive from inherited accounts could be subject to a higher combined tax rate.
2. To obtain benefits from having less taxable income in retirement years, such as reduced Medicare B premiums. The 2019 monthly Medicare B premium of $135.50 jumps 40% if a taxpayer’s income is just one dollar over $85,000 (for unmarried taxpayers, or $170,000 on a married joint return) and can climb as high as $460.50 per month.9 See “2019 Medicare B Premiums,” this page. By reporting less taxable income in retirement, a taxpayer might pay reduced premiums. Of course, if a Roth IRA conversion takes place while an individual is enrolled in Medicare, then the income from the conversion could significantly increase the Medicare B premiums attributable to that year.
3. Roth IRAs are great vehicles to save for capital expenditures in retirement, such as a new car. Whereas individuals over age 701/2 are generally supposed to receive required minimum distributions (RMDs) each year from their IRAs and other QRP accounts, a Roth IRA is exempt from any lifetime RMD requirement.10 As illustrated in “Lifetime RMDs,” p. 33, each year’s RMD is between 3.65% and 5.13% of an account balance in an individual’s 70s and between 5.35% and 8.33% of an account balance in an individual’s 80s. A Roth IRA permits individuals who have virtually all of their assets tied up in retirement accounts to avoid distributions and thereby accumulate amounts in their Roth IRAs until they need to spend it on a major expenditure. Furthermore, because the Roth IRA distribution is exempt from income tax, a large Roth IRA distribution won’t push an individual into a higher marginal income tax bracket or generate higher Medicare B premiums.
Whereas Roth 401(k) and Roth 403(b) accounts are subject to lifetime RMDs,11 these accounts can be rolled over to a Roth IRA when there’s no lifetime RMD requirement.12 After death, a Roth IRA is subject to basically the same RMD requirements that apply to a traditional IRA or QRP account after an account owner’s death.13 A Roth IRA is only exempt from the lifetime RMD requirement.
4. The individual is so wealthy that the inflated pre-tax dollars in the retirement accounts will be subject to the federal estate tax or to a state estate or inheritance tax (for residents of Connecticut, District of Columbia, Hawaii, Iowa, Illinois, Kentucky, Massachusetts, Maryland, Maine, Minnesota, Nebraska, New Jersey, New York, Oregon, Pennsylvania, Rhode Island, Vermont and Washington). If someone dies with a traditional IRA or QRP account, then the entire account is subject to estate or inheritance taxes. That means that estate taxes are levied on the deferred income taxes in the account.14 Thus, an advantage of a Roth IRA conversion is that it purges the deferred income taxes from a traditional pre-tax IRA or QRP account. The estate tax is only levied on the true economic value of the account, which is its after-tax value. Furthermore, the payment of the income tax on the conversion will reduce the size of the taxable estate.15
If there’s no Roth IRA conversion, then the beneficiaries of a traditional retirement account must report distributions as taxable income in respect of decedent.16 They can’t claim any income tax deduction for the payment of any state estate or inheritance tax. There is, however, an income tax deduction available for paying the federal estate tax. Internal Revenue Code
Section 691(c) permits beneficiaries to claim an income tax deduction for the federal estate tax that was attributable to the retirement assets. However, many beneficiaries fail to get any tax savings from this deduction.17
An alternative to leaving the taxable retirement assets to children or doing a Roth IRA conversion is for a charitably inclined individual to name her favorite tax-exempt charitable organizations as beneficiaries of the inflated pre-tax retirement assets. The charitable bequest will generate a charitable deduction on the estate tax return for the full amount.
5. If stock market valuations take a hit, the low stock prices can be an opportunity to pay less tax on a Roth IRA conversion compared to when stock valuations are high. But, if stock prices continue to decline after the conversion, taxpayers are no longer able to reverse the Roth IRA conversion. They’ll be stuck paying income tax on the amount of income generated by the conversion. Until 2018, people who made a Roth IRA conversion were able to undo the conversion with a recharacterization, thereby permitting them to try and do a Roth IRA conversion in a future year when stock prices might be lower.18 After 2017, Roth IRA conversions are final and can’t be reversed.
When Conversion Makes Less Sense
Here are three situations:
1.Income from retirement plan distributions is expected to be subject to lower tax rates in future years. Perhaps the individual will have less income during retirement. Or, he might currently live in a state with high income tax rates and might move to a state that has no income tax or, after death, might leave the assets to beneficiaries who live in such a state.
2. The extra income from the Roth IRA conversion might push the individual into a higher income tax bracket or trigger other adverse consequences.
3. The individual doesn’t have the cash to pay the income tax that will be triggered by the Roth IRA conversion. A tax trap for individuals under age 591/2 is the standard procedure during a Roth IRA conversion whereby an IRA administrator asks the IRA account owner whether he would like income taxes withheld on the Roth IRA conversion. Don’t do it! The withheld taxes will be treated as a taxable distribution, and if the account owner is under age 59½, there will be a 10% penalty on the amount of the withheld taxes.
Potential Taxes and Penalties
If everything goes well, then a distribution from a Roth account (a Roth IRA, Roth 401(k), Roth 403(b) or Roth 457(b)) is completely exempt from federal and state income taxes. However, there are situations when there could be income taxes or penalties on a Roth distribution:
1. For individuals over age 591/2, the investment income earned by a Roth IRA could be taxable if the Roth IRA owner hadn’t had a Roth IRA for at least five years or if he inherits a Roth IRA that was established or converted by the decedent within five years of the distribution.
2. For individuals under age 591/2, all distributions of a Roth IRA’s investment income are taxable and are generally subject to the 10% penalty for early distributions. Furthermore, the receipt of an amount that was converted with a Roth IRA conversion within five years of the distribution is also subject to a 10% penalty. Neither of the 10% penalties apply to distributions received from an inherited account. Still, the investment income of an inherited account could be taxable under the same rules that apply to beneficiaries over age 591/2.
The 5-Year Rule
For a distribution of the investment income of a Roth IRA to be excluded from gross income, it must be made: (1) after the individual attained age 591/2, became disabled, acquired a first home or died;19 and (2) more than five years after the taxpayer made a contribution or conversion to a Roth IRA.20 A similar 5-year fermentation period applies to the investment income of an account in a Roth 401(k), Roth 403(b) or Roth 457(b) plan.21
For an individual over the age of 591/2, a distribution of investment income within the 5-year period is taxable. The 5-year period is measured by full tax years. For example, if a 60-year-old individual makes her first Roth IRA contribution on Nov. 15, 2020, then any distribution of investment income made on or after Jan. 1, 2025 is tax exempt, because the 5-year computation is made using taxable years. However, any distribution of income before Dec. 31, 2024 will generally be taxable.
The 5-year rule is a once-in-a-lifetime test for an individual’s own Roth IRA (but not for an inherited Roth IRA). That is, distributions of investment income are tax-exempt if they’re made more than five years after a taxpayer made her first contribution or conversion to any Roth IRA.22 Thus, if an individual made a contribution to any Roth IRA (or made a Roth IRA conversion) in 2015 or earlier, then that individual will have satisfied the 5-year fermentation requirement for any Roth IRA distribution in 2020 or any later year.23 The 5-year period also applies to any individual who establishes his first Roth IRA with a tax-free rollover from a Roth 401(k), Roth 403(b) or a Roth 457(b). Even though all of the assets held by the Roth IRA are essentially after-tax dollars received from another Roth account, a distribution of the Roth IRA’s investment income will be taxable if made within four years of its establishment.24
Account Owners Under Age 591/2
A distribution of investment income from a Roth IRA to someone under age 591/2 is taxable regardless of how many years he may have had the Roth IRA. The taxable distribution is also subject to the usual 10% penalty that applies to early distributions from traditional retirement plans,25 although the penalty won’t apply to a distribution from an inherited account.26
Distributions from inherited Roth IRAs. An individual who’s passed the once-in-a-lifetime test for his own Roth IRAs must still be concerned about distributions from an inherited Roth IRA. The 5-year rule is determined based on when the decedent established a Roth IRA.
For example, assume that a 60-year-old individual made his first Roth IRA contribution in 2005, so that all distributions of investment income from his own Roth IRAs are clearly tax exempt. He learned that he’s the sole beneficiary of his aunt’s Roth IRA. His aunt had made a Roth IRA conversion in December 2016 and had never had a Roth IRA before. His aunt died in 2018, and the individual liquidated the aunt’s Roth IRA account in May 2019. All of the accumulated investment income in his aunt’s Roth IRA is taxable because the distribution didn’t occur more than five years after his aunt had made a contribution or conversion to her first Roth IRA in 2016.27 If he’d waited until January 2021 to receive the investment income, then the investment income would have been tax exempt, because it would have been distributed more than five years after his aunt’s first contribution/conversion to a Roth IRA. This is the rule for inherited accounts regardless of whether the beneficiary is under or over age 591/2.
What can be done if an individual inherits a Roth IRA from someone who made his first Roth IRA contribution or Roth IRA conversion within five years of death? Avoiding all distributions for up to five years after death isn’t advisable. To qualify for a stretch payout over the beneficiary’s remaining life expectancy, payments must begin in the year following death.
Fortunately, there’s a good tax outcome. This is because distributions from a Roth IRA are deemed to be made first from tax-free amounts, so that the recipient won’t receive any taxable investment income until all tax-free amounts have been distributed. Distributions are deemed to be made: (1) first from non-deductible contributions made to the Roth IRA (a tax-free return of capital), (2) then from tax-exempt Roth IRA conversion amounts (also a tax-free return of capital—but see below if the recipient is under age 591/2), and (3) last from investment income accumulated during the Roth IRA years.28 Thus, in the above example, the individual could safely withdraw the converted amounts in 2019 and 2020 and then wait until January 2021 or later years to withdraw the investment income.
Penalty for distributions of converted amounts to someone under age 59½. A tax policy concern was that individuals under the age of 591/2 might be able to avoid the 10% penalty for early distributions from IRAs and QRPs by doing a Roth IRA conversion. That is, they could do a Roth IRA conversion in one year (which is exempt from the 10% penalty) and then quickly withdraw the converted amounts in the next year and claim that they received a tax-free return of previously taxed capital. Consequently, Congress enacted a 10% penalty if an individual under age 591/2 receives a converted amount within five years of a Roth IRA conversion.29
The 10% early distribution penalty that typically applies only to a distribution of taxable income from a traditional retirement plan will also apply to a distribution of a tax-exempt Roth IRA conversion amount made to an individual under age 591/2. Unlike the once-in-a-lifetime 5-year computation that determines the taxability of a Roth IRA’s investment income, this 5-year computation is made separately for every year in which a Roth IRA conversion occurs. The penalty doesn’t apply if the distribution of the converted amount is made under circumstances that would exempt a distribution from a traditional retirement plan from the 10% early distribution penalty, such as a distribution from an inherited retirement account.30
Next Step
The easiest way to do a Roth IRA conversion is to contact an IRA administrator and arrange for a trustee-to-trustee transfer to the Roth IRA from a traditional IRA or from an employer retirement plan account.31 Although a 60-day rollover is another possible method, it’s less attractive because of potential income tax withholding and a greater chance of mistakes, such as missing the 60-day deadline. 32
Endnotes
1. Internal Revenue Code Sections 408A(d)(3)(A)(i) and (ii); Treasury Regulations Sections 1.408A-4, Q&A-1 (c) and 1.408A-4, Q&A-7.
2. There’s no 10% penalty for a Roth individual retirement account conversion before age 591/2, but the penalty can apply if a converted amount is distributed within five years of the conversion to a Roth IRA owner who’s under age 591/2. . Compare IRC Sections 408A(d)(3)(A)(ii) and 408A(d)(3)(F).
3. Bruce D. Steiner, “Tax Reform Opens a Window for Roth Conversions,” Trusts & Estates (June 2018).
4. IR-2018-211 and Internal Revenue Service Notice 2018-83; 2018-47 IRB 1 (Nov. 1, 2018).
5. Until 2010, a Roth IRA conversion was prohibited if an individual’s modified adjusted gross income (MAGI) exceeded $100,000. IRC Section 408(c)(3)(B) (2009). That restriction was eliminated beginning in the year 2010 by Section 512 of the Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222.
6. The only law concerning conversions appears in the Roth IRA statute: Section 408A. Furthermore, as a practical matter, individuals who are still employed will generally find it easier to convert a traditional IRA to a Roth IRA, rather than convert a retirement account with their employer plan. For example, a 401(k) plan is prohibited from making a distribution (other than a hardship distribution) to an employee until he separates from service or has attained age 591/2. IRC Section 401(k)(2)(B)(i).
7. For example, assume that an individual is in a 30% marginal income tax bracket (combined federal and state) both in the year of contribution and in the year of distribution. If he earns $1,000 and deposits it into an IRA, and if the investments grow tenfold, he’ll end up with $7,000 of after-tax dollars in the year of distribution, regardless of whether the IRA was a traditional IRA or a Roth IRA. That is, an individual could deposit $1,000 into a traditional IRA and claim an income tax deduction or could pay $300 (30%) of income tax and deposit the remaining $700 of after-tax dollars into a Roth IRA. If the investment in the traditional IRA grows tenfold to $10,000, and the individual withdraws that amount, he would pay 30% income tax in the year of withdrawal ($3,000) and would end up with the same $7,000 of after-tax dollars in the Roth IRA that made the same tenfold investment.
8. For example, if an individual contributes the maximum annual $6,000 limit to an IRA, a deposit of $6,000 of after-tax dollars into a Roth account will produce more after-tax wealth than a deposit of $6,000 of pre-tax dollars into a traditional IRA. The pre-tax dollars will ultimately be taxed in the future and will leave a smaller balance. Put in perspective, if an individual is in a 30% marginal tax bracket, then contributing $6,000 of after-tax dollars to a Roth account is the equivalent of depositing nearly $8,600 into a traditional retirement account.
9. 2019 Medicare B premiums are based on MAGI reported in the year 2017, www.medicare.gov/your-medicare-costs/part-b-costs.
10. Section 408A(c)(5). The minimum distributions requirement for qualified retirement plans appears in IRC Section 401(a)(9) and for IRAs in IRC Section 408(a)(6).
11. Section 402A(e)(1)(B).
12. Treas. Regs. Sections 1.402A-1, Q&A-1 and 1.408A.
13. A stretch arrangement is possible: A Roth IRA can be liquidated over a designated beneficiary’s life expectancy (typically until the beneficiary attains age 83, 84 or 85). Treas. Regs. Section 1.408A-6, Q&A-14(b) (Roth IRA) and Treas. Regs. Section 1.401(a)(9)-5, Q&A-5(a) through (c) and Q&A-6 (traditional accounts). However, stretch treatment generally isn’t permitted if one of the beneficiaries of the account isn’t a human being (for example, the beneficiary is the decedent’s probate estate). Treas. Regs. Section 1.401(a)(9)-5, Q&A-5(a)(2) and 5(c)(3). If a Roth IRA fails to qualify for stretch treatment, then the Roth IRA must be liquidated within just five years after the owner’s death. Treas. Regs. Section 1.408A-6, Q&A-14(b).
14. For example, if an individual will always be in a 33% income tax bracket, then the after-tax value of a $150,000 pre-tax retirement account is $100,000, because a liquidation of the account would trigger a $50,000 income tax liability. Yet, if that individual dies and the retirement assets are subject to the federal estate tax or to a state estate tax, that tax will be levied on the entire $150,000. The estate will be paying estate tax on the $50,000 of deferred income taxes.
15. The payment of the income tax on a Roth IRA conversion reduces the size of the taxable estate. In the example cited in the previous endnote, an individual over age 591/2 could do a Roth IRA conversion of $100,000 and use the remaining $50,000 to pay the income tax, thereby reducing the taxable estate by $50,000. Because the investment income of a Roth account is tax exempt, having a $100,000 Roth account means that the individual is no worse off than if he had $150,000 in a fully traditional taxable account. On the other hand, if the individual is under age 591/2, then the individual shouldn’t use the remaining $50,000 to pay the income tax. A distribution of the $50,000 would subject the individual to the extra 10% tax applicable to receiving a taxable distribution from a retirement account before age 591/2. IRC Section 72(t). For an individual under age 591/2, it’s therefore essential that there be other non-retirement assets available to pay the income tax liability.
16. Revenue Ruling 92-47.
17. The IRC Section 691(c) deduction for federal estate taxes is an itemized deduction. IRC Section 67(b)(7). Considerably fewer taxpayers claim itemized deductions since the enactment of Tax Cuts and Jobs Act (TCJA). The Joint Committee on Taxation projected that the number of returns that claim itemized deductions would fall from 46.5 million in 2017 to approximately
18 million in 2018 and future years. See “Tables Related to the Federal Tax System As In Effect 2017 through 2026,” JCX-32R-18 (April 24, 2018). Furthermore, there’s anecdotal evidence that many eligible beneficiaries failed to claim the deduction because they weren’t informed of its existence, or the information is lost when distributions take place over a large number of years (for example, a stretch IRA over the beneficiary’s life expectancy).
18. Section 408A(d)(6) (year 2017), repealed by TCJA, P.L. 115-97.
19. Sections 408A(d)(2)(A)(iv), 408A(d)(5) and 72(t)(2)(F).
20. Section 408A(d)(2)(B); Treas. Regs. Section 1.408A-6, Q&A.
21. Section 402A(d)(2)(B); Treas. Reg. Section 1.402A-1, Q&A-4.
22. Section 408A(d)(2)(B); Treas. Regs. Section 1.408A-6, Q&A-2 (“first regular contribution is made to any Roth IRA”).
23. Treas. Regs. Section 1.408A-6, Q&A.
24. Treas. Regs. Section 1.408A-10, Q&A-4.
25. Treas. Regs. Section 1.408A-6, Q&A-5(a).
26. Section 72(t)(2)(A)(ii).
27. Treas. Regs. Section 1.408A-6, Q&A-7 and Q&A-11.
28. Treas. Regs. Section 1.408A-6, Q&A-8. Section 408A(d)(4)(B)(i) (conventional annual contributions) and Section 408A(d)(4)(B)(ii) (conversion contributions). See also Treas. Regs. Section 1.408A-6, Q&A-9&10.
29. Section 408A(d)(3)(F) and Treas. Regs. Section 1.408A-6, Q&A-5(b)&(c) and Q&A-10, Examples (4) and (6). Such a 10% penalty doesn’t violate the U.S. Constitution. Kitt v. U.S., 277 F.3d 1330 (Fed. Cir. 2002), aff’d 288 F.3d 1355 (Fed. Cir. 2002).
30. For example, a distribution is exempt if it’s made after age 591/2 or if there’s a disability, death or medical hardship. Treas. Regs. Section 1.408A-6, Q&A-5(b) (last sentence: “The exceptions under section 72(t) also apply to such a distribution.”)
31. Treas. Regs. Section 1.408A-4, Q&A-1(b)(3) (IRAs) and Treas. Regs. Section 1.408A-4, Q&A-1(b)(2) (employer plan).
32. Treas. Regs. Section 1.408A-4, Q&A-1(b)(1). Furthermore, a trustee-to-trustee transfer has no income taxes withheld, whereas a 60-day rollover may require an employer plan administrator to withhold 20% for income tax. Treas. Regs. Section 1.408A-6, Q&A-13.