by Michael Hart
Investment Advisor Representative
[email protected]
One of the questions going into this election cycle was what would happen with the Trump tax cuts which were set to expire after 2025. With the election over and done with, it looks more and more likely like those cuts will be extended. This could impact how older adults approach their tax planning, particularly when it comes to Roth IRA conversions.
Traditionally, it hasn’t made much sense for older savers to convert their traditional IRAs to Roth IRAs, mainly because of the immediate tax implications: account holders would have to pay taxes both on their required minimum distributions (RMDs) and on the conversion amount itself. However, given the current tax landscape, it may be time to reconsider. If an older adult has an adequate income in retirement, or large 401(k)s they rolled over to an IRA, Roth conversions can make sense.
I’m sure you remember the primary difference between traditional IRAs and Roth IRAs, but here’s the crash course. With traditional IRAs, the contributions go in tax free and the withdrawals are taxed. You get the seed for free but you pay on the harvest. With Roth IRAs, the contributions go in having been taxed, but the withdrawals come out tax-free. You pay tax on the seed but get the harvest for free.
The reason many retirees consider a Roth conversion is that traditional IRAs come with required minimum distributions (RMDs), which start at age 73 (or at 75 if they’re born after 1959) whether they need the money or not. It’s a double-whammy, because the money coming out 1) is taxed and 2) is no longer growing. If the funds are converted from a traditional IRA to a Roth IRA, however, once the taxes on the converted funds are paid all future withdrawals including any investment gains are generally tax-free. Plus, the account holder is no longer required to take RMDs on the Roth funds.
If you’re considering a Roth conversion and are older… or in poor health… beware the “widow’s penalty.” This refers to the tax implications that often arise after one spouse passes away. The surviving spouse may face higher tax rates despite having less income due to reduced Social Security benefits, pensions, or other sources.
- Change in Filing Status: After the death of a spouse, the surviving partner typically must switch from filing taxes jointly to filing as a single taxpayer in the following year. This shift means lower income thresholds for each tax bracket.
- Impact on Tax Rates: While a small jump in tax rates—from 22% to 24%, for example might not seem significant, it can have a substantial impact if the increase is from 24% to 32% or higher. This can affect even those in moderate income brackets, leading to a higher overall tax burden.
By converting some traditional IRA funds to a Roth IRA while both spouses are still living and filing jointly, it’s possible to reduce the tax burden on the surviving spouse. Since Roth IRA withdrawals are tax-free, this strategy can help shield the surviving spouse from being pushed into higher tax brackets, especially in the face of the widow’s penalty.
There are a lot of factors to look at when deciding to do Roth conversions and deciding how much to convert. These are just some of the decisions that Peter, Rob, Kyle, Nick, and myself help people with every day. So if you have questions or know anyone who has questions, give a call or shoot us an email.
Otherwise, have a great weekend!