The Build Back Better Act has gotten a lot of press for the intended means to pay for it – by raising taxes. These proposals include directly raising the top tax rate for single filers whose income is above $400,000 and essentially ending the long-term capital gains tax rate, among other increases.
While these changes may get headlines, other elements will also have an impact, particularly for retirees. Roth conversions are a staple for retirement planning as they allow for tax-free growth, more flexibility in income planning, and do not have required minimum distributions.
Eliminating them would constrain retirement plan flexibility, potentially limit the growth of capital, and could even create income levels that would trigger the Medicare Part B surtax.
We break down the impact and get into why Roth conversions are a useful retirement tool.
The Current State of the “Negotiations”
The current $3.5 trillion price tag for the Build Back Better Act is likely to be reduced. Democrats on both ends and in the middle are vigorously pursuing a broad range of postures that pass for negotiations, but at this point, there’s no telling what is on the chopping block.
However, even if the plan’s cost shrinks, changes to Roth conversions may not be left out. The impetus behind these changes is around making these retirement strategies more focused on the middle class, which is why they are being either phased out above certain asset levels or limited above certain income levels.
What are the Proposed Changes?
The Act would essentially repeal the conversion of pre-tax dollars held in a traditional IRA or 401(k) to a Roth IRA or 401(k). For income levels of $400,000 and above, Roth conversions would be ended on December 31, 2031.
Why Does This Matter? Let’s Review Roth Conversions
Traditional retirement accounts are funded with pre-tax dollars. You take a deduction on your taxes in the year you contribute and defer those taxes until you take distributions in retirement. When you convert to a Roth, the taxes on those amounts must be paid. Currently, there are no age or income restrictions on Roth conversions.
If you are age 59½ or older and the Roth is at least five years old, withdrawals will be tax-free. This means you don’t have to worry about withdrawals bumping your income to a level that will expose you to excess taxes on Social Security benefits (85% of which are taxable) or require you to pay the dreaded “IRMMA” or Medicare Part B Premium surtax.
The Medicare tax has a two-year lookback, which makes it even trickier to manage income. If you have a year when you travel, help out your kids or grandkids, or make a big purchase and pull from retirement accounts to fund it, you don’t have to worry about getting hit with the penalty a couple of years later.
Another benefit is that Roths don’t have required minimum distributions (RMDs). This allows you to keep assets growing in strong markets and avoid crystalizing losses if markets are down. The Roth conversion can also be an effective estate planning strategy, as it allows for the transfer of the funds tax-free.
Strategizing the Timing
Converting Traditional retirement accounts to a Roth requires careful planning. Because it will impact your income and your taxes in the year you convert, it’s generally a good idea to wait until you are either already in retirement, or otherwise have a year (or several) when income will be lower. There is a sweet spot – essentially the early years of retirement, before age 72 when RMDs kick in.
Given the new potential deadline of December 31, 2031, it may be a good idea to have a look at your long-term financial plan and see how a Roth conversion fits in with other strategies, such as selling an investment property or diversifying a concentrated equity position. That of course will trigger capital gains – but that’s a blog for another day.
The Bottom Line
The extent of the tax regime changes that will end up becoming law as the Build Back Better Act is slowly coming into view – and while they will definitely result in investors paying higher taxes, the sooner you get started planning, the more options there will be to minimize them.
