Roth IRA Conversions For Early Retirees
Roth IRA conversions could make sense for early retirees who are able to control their income and avoid falling into a high tax bracket.
In early 2010, I wrote an article about converting traditional IRAs to Roth IRAs as a hedge against higher future tax rates. Traditional IRAs are funded with pre-tax dollars and growth within the account is tax deferred until retirement, at which time the taxpayer owes ordinary income tax on all distributions. Roth IRAs are funded with after-tax dollars, but distributions during retirement are tax free.
In general, traditional IRAs are attractive for those who believe that their tax rate during their working years will be higher than their tax rate in retirement. This is often the case since it is not unusual to be in a lower tax bracket during retirement. However, this is certainly not the case for all taxpayers and it is possible that all tax brackets could increase in the future.
The following is an excerpt taken from my article written fourteen years ago:
The dire fiscal situation of the United States is likely to lead to much higher taxes in the future, particularly on those who are in higher tax brackets. Recent health care legislation broke precedent by subjecting certain types of investment income to Medicare taxes for higher income taxpayers. While it appears that retirement plan distributions will not be subject to the Medicare tax, this could change in the future. Of course, there is always the risk that the government may try to break its pledge to treat Roth IRA distributions as tax free for higher income taxpayers. However, this seems less likely than moves to tax investment income outside retirement accounts.
One of the great benefits of writing, whether in a personal journal or on a public website, is that we cannot lie to ourselves about what we thought in the distant past. While the overall message of my article holds up well, I was completely wrong about the United States having “much higher taxes in the future, particularly on those who are in higher tax brackets.” I did not foresee the Trump administration’s 2017 tax legislation which cut tax rates across the board. I believe that the fiscal situation is far worse today than it was in 2010, but does it necessarily follow that tax rates will be higher in the future? Past history suggest that we cannot be confident about predicting future taxes.
We live in an era of multi-trillion dollar annual federal deficits, with the shortfall for fiscal 2024 coming it at an astounding $1.8 trillion. The pandemic caused a flurry of spending during 2020 and 2021. Reasonable people can disagree regarding whether this spending was justified in response to the pandemic shutdowns, or whether the shutdowns themselves were justified. It is less reasonable to assert that this high level of spending should become the new baseline, but that is precisely what has happened. The federal government has a spending problem, not a revenue problem, and both parties are to blame for fiscal incontinence. Neither presidential candidate has proposed any credible plan to reduce the tsunami of red ink.
Given that spending will surely not decline to pre-pandemic levels, it would seem reasonable to assume that tax revenues will eventually need to rise. If Vice President Harris wins the Presidency and the Democrats take control of both Houses of Congress, tax rates will certainly rise on higher income earners starting in 2026, but a clean sweep is anything but assured. Republican control of either House of Congress could block higher tax rates, and a second Trump administration will certainly not accept tax increases.
Getting back to the topic of this article, should early retirees consider Roth conversions as a hedge against the possibility of higher tax rates? Obviously, much depends on whether the tax rate that one pays on conversions will be less than the future tax rate that would be owed on traditional IRA distributions. However, the matter is far more complex than simply considering the income tax rate that would apply. This is because required minimum distributions from IRAs could result in higher adjusted gross income (AGI) which is a measure that determines how much seniors must pay for Medicare Part B and Part D premiums. This adjustment, known as IRMAA, can be substantial at surprisingly low levels of income:
It should also be noted that exceeding the income thresholds by even a dollar will result in a higher monthly adjustment. IRMAA is determined based on modified AGI two years earlier. So, the IRMAA adjustment for 2025 will be based on modified AGI in 2023.
Roth IRA distributions are tax free and are not considered “income” for purposes of IRMAA. At least, this is the case under current tax law. While the government could attempt to either tax Roth IRA distributions directly or to include Roth IRA distributions in IRMAA, both of these moves would effectively repudiate the entire premise of the Roth IRA account and would face serious bipartisan opposition. As a result, Roth IRA conversions could be a good way to manage Medicare premiums later in life.
Early retirees often have greater ability to time their taxable income compared to older retirees who may be receiving pension and social security benefits. My case is an extreme example. I left traditional employment in 2009 at the age of thirty-five and the bulk of my assets in taxable accounts were in stocks, including Berkshire Hathaway, that did not pay dividends. Over the years, I have generated cash flow for my living expenses mostly through capital gains and I have complete control over the timing of such income.
In 2009, I moved my traditional 401k account into a traditional IRA. Over the years, I spread out Roth IRA conversions in a manner that never resulted in paying a high tax rate. Today, over half of my retirement assets are in my Roth IRA. While my decisions seemed optimal in any given year, in retrospect I was not aggressive enough with Roth conversions. My IRA assets have compounded at a rate materially higher than my taxable account, most likely due to the freedom I felt to make portfolio changes without incurring immediate tax liabilities. If I had converted my entire traditional IRA to a Roth IRA in 2010, I would have paid substantial taxes, but it would pale in comparison to the deferred tax liability on my traditional IRA today.
But the past is the past.
The question is whether I should be more aggressive with Roth IRA conversions in the future. Marginal tax rates are quite low today by historical standards and seem very unlikely to be lower in the future:
The “sweet spot” in the tax code is currently the 24% tax bracket which includes taxable income up to $191,950 for single filers and $383,901 for married filers. Above those thresholds, the marginal tax rate jumps up sharply to 32%. Former President Trump is likely to resist any tax increases for any bracket while Vice President Harris claims to be opposed to tax increases for “households” earning up to $400,000. This would appear to make the 24% bracket sacrosanct beyond 2025 when the 2017 tax cuts expire, but politicians can never be fully trusted so nothing is certain.
This article would not be complete without mentioning one serious wrinkle to the situation related to the “Affordable Care Act,” also known as Obamacare. The ACA offers substantial subsidies for taxpayers that phase out as adjusted gross income increases. The effect of the reduction of subsidies as income rises is exactly the same as a marginal tax. As a result, anyone who is considering substantial Roth IRA conversions must be willing to accept the loss of all ACA subsidies. I have written about the ACA before, but readers should be aware that subsidies were made far more generous since that article was published in 2017. There is a possibility that ACA subsidies will become less generous after 2025, although I doubt this will be allowed to happen regardless of who wins the Presidency or which party controls Congress.
It is also important to have funds in a regular taxable account available to pay the taxes owed as a result of the conversion. If an individual would have to tap retirement accounts to pay taxes, that would most likely make very little sense, especially for those younger than 59 1/2 years of age since early withdrawal penalties are likely to apply. This would have the effect of increasing the effective tax rate owed on the conversion.
The decision to convert all or part of a Traditional IRA to a Roth IRA is complicated and involves many assumptions in an environment of considerable uncertainty. My current opinion is that tax rates are far more likely to be higher in the future than they are today regardless of what current politicians are promising. However, I made the same precision in 2010 and I was obviously wrong.
I am also concerned that the government might renege on the promise to treat Roth IRA distributions as tax free. Even if Roth IRA distributions are not directly taxed, the government could include Roth IRA distributions in the modified AGI figure used to determine Medicare premiums. However, any move like this will cause a massive outcry and the opposition is likely to be bipartisan.
I would love to convert my entire Traditional IRA to a Roth IRA immediately but this would result in paying the top marginal tax rate, so my approach is likely to involve conversions over a period of several years with the goal of limiting my marginal tax rate to 24%. I am not even certain that I will be that aggressive. I suspect that my “future self” will be thankful if I am more aggressive than my “present self” might prefer.
I could rationalize Roth conversions and payment of current taxes to be a contribution to correcting the federal budget imbalance, but this amounts to a minuscule drop in a vast ocean. Our political climate is not likely to fix the budget until a crisis forces action, and at that point all options could be on the table. Roth IRA accounts, especially owned by “the rich,” could be a tempting target. There is precedent for retroactive changes governing IRA accounts. In 2020, the federal government drastically limited the “stretch” IRA strategy which amounted to reneging on a previous promise and upending many carefully planned estates.
The federal government clearly cannot be trusted. But we still have to make decisions about the future.
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