By: David K. Carboni, Ph.D.,CFPⓇ
For 2020, someone with earned income may contribute up to $6,000 to an IRA (an extra $1,000 if the person is age 50 or older). There are two types of IRAs: Traditional IRAs and Roth IRAs. However, to be eligible to contribute to a Roth IRA your modified adjusted income (MAGI) must fall below $139,000 for single filers, and $206,000 for married couples filing jointly.* For single filers with MAGIs between $124,000 and $139,000, and marrieds filing jointly with MAGIs between $196,000 and $206,000, only partial contributions are allowed.
But the law does allow anyone, regardless of income, to convert all or some of the assets from traditional IRAs, 403bs, and 401ks to a “tax free” Roth IRA. But there’s a huge catch: any un-taxed dollars built up in the IRAs, 401ks, and 403bs converted to the Roth account will be taxed upon conversion (on top of the taxpayer’s other taxable income). Once converted, the account becomes a Roth IRA with all its associated benefits, including: tax-free withdrawals after 5 years, and reaching age 60, whichever comes later.
There’s a tax planning maxim: “never pay taxes earlier than required”. However, 2020 may be a good year to violate this tenet.
A Roth IRA has additional benefits that go beyond its tax free status. For example, Roth IRAs are exempt from required minimum distribution rules as well. This means, unlike regular IRAs, IRA rollovers, 401ks, and 403bs, Roth IRAs exempt taxpayers from the requirement to make minimum withdrawals from the account after age 701/2. Some resent the idea of the government forcing them to make withdrawals and find this Roth feature particularly attractive.
Likewise, as mentioned earlier, withdrawals by those who inherit Roth IRAs are also tax free. This particularly appeals to those who don’t intend to use the assets during retirement. 2025 Federal tax rates will are scheduled to return to the somewhat higher rates of 2016. The deficit is exploding, even before the Pandemic If so, the Roth’s ability to avoid future taxation has added appeal.
All these considerations must ultimately return to the question, should you convert to a Roth IRA in 2010? The focus here will be on the issues facing the 97% of the population with incomes below $250,000 for married couples, and $200,000 for single filers. The taxpayers must first identify their current tax bracket and make an estimate of their future tax bracket in retirement. Your tax bracket is the rate at which the next dollar of income you receive is taxed. So, if you’re in the 15% tax bracket, and you get a $1000 raise, you’ll pay an additional $150 in federal taxes. By the way, in 2010, a married couple’s taxable income must exceed $68,000 before exiting the 15% tax bracket into the 25% bracket. Generally, taxable income refers to all your income less: your contributions to your retirement plans (like your 403b), your tax deductions, and your personal exemptions. After applying these deductions, exemptions, and retirement plan contributions, many married jointly taxpayers with incomes approaching $100,000 are in the 15% tax bracket. Most retirees are in the 15% tax bracket, and it’s likely that most will be in the future, as the federal tax tables’ brackets rise each year with inflation
In practice, most taxpayers’ tax brackets go down in retirement. Not only will their income be less, but not all retirement income is subject to tax (e.g., only a portion of Social Security benefits are taxable). Therefore, for employees approaching retirement there’s no need to rush to convert to a Roth IRA in 2010. Generally, if you are intent on converting, you’d probably be better off waiting until you retire when your tax bracket will be lower.
Employees who are early in their careers are likely to be in a relatively low tax bracket. It could make sense for them to convert in 2010, to take advantage of the tax free life-time growth Roth IRAs provide (along with the income splitting rule). These younger employees should plan to pay the additional tax due in 2011 and 2012 from sources other than their retirement accounts. Failing to do so would partially defeat the purpose of the conversion.
In unlikely event that you will be in a higher tax bracket in retirement, converting some or all of your eligible retirement accounts to a Roth in 2010 could very well make sense. Never the less, it’s prudent “run the numbers” using one of ubiquitous “Roth Conversion Calculators” available on many financial service firms’ websites to tailor the numbers to your circumstances. Fidelity Investments has a good one at www.fidelity investments.com.
One positive result of all the hoopla around 2010 Roth IRA conversions is its reminder to employees to reduce their taxes by using the tools they have available. These include: maximizing contributions to your 403b accounts, using your flexible spending accounts, and making eligible contributions to IRAs (including spousal IRAs). It’s never too late to formulate and implement a plan to reduce your taxes. Or, as someone once said, “it’s not how much you earn, it’s how much you get to keep after taxes.”
*Modified Adjusted Gross Income starts with your Adjusted Gross Incomes and adds back certain exempt amounts. A phase-out for eligibility for single filers ranges for MAGIs between $107,000 and $122,000, and $169,000 to $179,000 for married filing jointly in 2020.