What You Need to Know About Roth Conversions Before the Tax Code Sunset

What Is the Difference between a Traditional IRA and a Roth IRA?

IRAs, also called individual retirement arrangements or individual retirement accounts, come in several forms. Two of the most common IRA types are traditional and Roth. Both are tax-advantaged retirement investing accounts, but they incur different tax benefits and restrictions.

Money contributed to a traditional IRA is tax-deferred. This means investors contribute pretax dollars but will be responsible for paying income taxes when they withdraw the money from the account in retirement. If you’re a high earner and you expect to be in a lower tax bracket later in life, it may be wise to invest in a traditional IRA. Tax-deferred accounts are one way to lower your taxable income in your peak earning years, and most high earners will be in a lower tax bracket once they retire, so their tax bills will decrease over the course of their lives.

In contrast, investors pay income tax on money contributed to a Roth IRA, but all contributions and earnings may be withdrawn tax-free in retirement. This is an excellent option for those who are in a lower tax bracket now than they expect to be in retirement, such as students, individuals in the early stages of their careers, professionals who are on sabbatical or another extended form of leave, and people benefitting from the historically low TCJA income tax rates. It’s important to note Roth IRAs have income limits that traditional IRAs do not. In 2023 the Roth IRA income limit for single tax filers is $153,000, and it is $228,000 for married couples filing jointly. Because of these limits, high earners cannot contribute directly to a Roth IRA. However, they can still take advantage of Roth conversions if they want the benefits of a Roth account.

What Is a Roth Conversion?

A Roth conversion occurs when an investor moves pretax traditional IRA funds into a Roth account, where the funds have the opportunity to grow tax-free. At the time of the conversion, the investor will have to pay income taxes on the fair market value of the money being converted, but they will then not have to pay taxes upon the withdrawal or growth of that money in retirement, thereby reaping the benefits of the Roth format.

How Will the Tax Code Sunset Affect Roth Conversions?

The TCJA tax code sunset will not make Roth conversions impossible, but it will make them more expensive and therefore slightly less attractive to some investors. The current, historically low TCJA income tax rates make it more likely that a person’s tax rate in retirement will be higher than their current tax rate. However, this may no longer be the case for exceptionally high earners when the sunset brings back pre-TCJA tax rates in 2025 or if rates increase for another reason. Additionally, the historically low income tax rate environment has made Roth conversions relatively inexpensive, but a return to pre-TCJA tax rates will make Roth conversions cost more because the converted funds will be taxed at the higher pre-TCJA rate. Whether performing a Roth conversion will still make the most sense for your financial plan after the tax code sunset will depend on several factors, including your current income and tax rate, the income and tax rate you expect to have when you retire, and the amount of money you already have invested in tax-deferred and taxable investing accounts.

What Next Steps Should I Take?

Though the TCJA tax cuts are expected to expire at the end of 2025, Congress may choose to extend the timeline or implement new laws altogether. Regardless of future changes, the current tax rates are comparatively low. If you’ve been considering a Roth conversion and think converting some or all of your traditional IRA contributions to a Roth IRA is a good fit for your current financial situation, now is a great time to perform a Roth conversion and take advantage of the historically lower income tax rates. Additionally, keep an eye out for developing news about government decisions regarding changes to income tax rates, and use that information to guide your decisions.