Is High Inflation a Good Time for Roth IRA Conversions?

Key Takeaways

• When it comes to taxes, inflation is great … The rates don’t change, but the brackets expand each year. When they expand, your tax bill becomes lower.
• One commonly dispensed piece of advice is that if you want to convert some of your IRA from traditional to Roth, you should convert enough just to the top of your tax bracket. You never want to leave a bracket unused because you don’t get it back. The key to tax planning is to always get your money out at the lowest rates, and that’s using to the fullest extent the brackets.
• Accelerating IRA withdrawals can be a good strategy to try to reduce your RMD subject balance. You would probably do that and put it in a Roth unless you needed the money for spending. You want to control your tax rates.
• The key is to take advantage every year you can of these giant, expanding brackets that have currently very low rates when it comes to your IRA money. So as long as you know it’s going to be taxed, get it on sale.

Christine Benz: Hi, I’m Christine Benz from Morningstar. Like March Madness, tax planning is all about the brackets, and tax and IRA expert, Ed Slott, says that inflation is your best friend. He is here to discuss how to use tax brackets to your advantage by trimming your IRA balances on your own terms.

Ed, thank you so much for being here.

Ed Slott: Great to be here.

How Does the Inflation Rate Affect Tax Brackets?

Benz: Ed, this can get a little bit complicated, but let’s start by discussing the relationship between inflation and tax brackets.

Slott: All right. You said I said that inflation is your friend. I understand inflation means things cost more. But when it comes to taxes, inflation is great. It’s great. It’s cost-of-living adjustments. The rates don’t change, but the brackets expand each year. A couple of years ago, we had the biggest bracket expansion. What does that mean? More funds can be passed through these lower brackets, through all the brackets. So, when they expand, your tax bill becomes lower. This happens every year. Even if there’s not a lot of inflation, there’s always some bracket creep cost of living index. So, the brackets expand, which means there’s your opportunity to have more of, say, your IRA funds, they’re going to be taxed anyway, go through these lower brackets.

Converting From a Traditional IRA to a Roth IRA Within Your Tax Bracket

Benz: One commonly dispensed piece of advice is that if I am converting, and say I’m retired and I want to convert some of my IRA from traditional to Roth, that I should convert enough just to the top of my bracket. Walk through what that means.

Slott: Well, you never want to leave a bracket unused because you don’t get it back. If you didn’t use part of the 22% bracket or something, you don’t get credit next year. Some people put it off and put it off until they’re forced to take required minimum distributions. It’s kind of like—I don’t know if this is a good analogy, it’s one I thought of recently—a baseball game. You have nine innings, three outs each inning. Would it be smart to only play the ninth inning and just use those three outs? Or would it be better to use the three outs in each of the other eight innings? Probably to get more chances at bat. That’s what these brackets are about. Use them every year. Don’t leave any unused, especially the low brackets. Historically low brackets we have now. We have 22%, 24%, or even lower brackets. But in the 22% and 24%, hundreds of thousands of taxable income can pass through at these unbelievably low rates. Why would you leave it till, say, the ninth inning when your IRA has expanded, has grown and grown, or maybe left to your beneficiaries who have only 10 years to get it out under the new rules, and they may only get one crack at it, who knows, at a higher bracket? Now you’re pushing these into a higher bracket …

The beneficiaries, I tell them the same thing, the 10-year people, even if you’re one of the beneficiary groups—without getting into the details—that can wait till the end of the 10th year, I tell them, why wait? Use the brackets all 10 years so you get low brackets each year. If you wait to take the whole shebang out at the end of the 10th year, once you’ve filled up 22% and 24%, and it’s probably so much now, you go to the higher brackets, you never got use of the earlier, the lower brackets. The key to tax planning is to always get your money out at the lowest rates and that’s using to the fullest extent the brackets.

So, you said, should I stop after 22%? I think it depends on your situation, but 24% is not a bad deal either.

Benz: It’s also a matter of projecting out into the future how my tax picture might change over time.

Slott: But I don’t see, and I don’t know—and everybody has opinions—I believe tax rates will have to go up in the future. But even if I’m wrong, I don’t know anybody who thinks tax rates will go down. I mean, we’re at rock-bottom historic lows. So even if they stay the same, you may be in a higher bracket if you’re not using, getting that money out, trimming these IRA balances and taking advantage of today’s low rates. And you may only have two years left to do this, part of this year, ‘24 and all of ‘25, in ‘26 rates are supposed to go up. We’ll see if that happens or not. I think that would be a shock to the system. But that’s what’s supposed to happen.

Benz: Yeah, the tax cut package is supposed to expire.

Slott: Right.

Benz: So, you’ve been mainly talking about conversions as a means of taking advantage of the brackets and kind of maxing out.

Slott: Well, that’s the main source of income you can control. You can’t control your job income. You can’t say, just give me enough pay to stay in the 24% bracket. Although I did have a client that did that one year as a teacher. He took a sabbatical because he didn’t want to go over a certain bracket and got it back in another.

Can Accelerating IRA Withdrawals Reduce Your RMD-Subject Balance?

Benz: How about accelerating IRA withdrawals? Is that ever a good strategy to try to reduce my RMD-subject balance?

Slott: Yes. And you would probably do that and put it in a Roth unless you needed the money for spending. You want to control your tax rates. After age 73, when RMDs, required minimum distributions, begin for IRA owners, now you’re not in control. Now you have a higher balance, could be at a higher rate, and it’s forced out. Imagine if all those years you were doing Roth conversions. First of all, you’d have a lower IRA, more in Roths, and lower RMDs and lower taxes in retirement, even if rates did go up because you have lower taxable income. So, you should be doing these things all year, these Roth conversions. You can still do Roth conversions once you reached RMD age, but they’re much more expensive. Because then you have to take the RMD and that has to come out first and the RMD itself cannot be converted. You have to take it and pay the tax. So, when you’re before RMDs, say, in your 60s or so, you can take funds out, voluntary withdrawals, or what I call unrequired distributions, and put it right in a Roth. Once you’re in RMD territory, you have to first take the RMD, that can’t be converted. Once that is satisfied, then yes, you can convert any part or all of the remaining balance, but it costs more because you had to take the RMD that couldn’t be converted.

So, imagine if say in your 60s, up to 73, a little each year, use those 12%, 24%, 22%, these incredibly low brackets. Over the years, you’ll be getting your IRA out at rock-bottom rates and piling up in the Roth. Remember the Roth IRA, the big benefit, no income tax. If you want to take it, you can. You don’t have to. There’s no RMDs for the rest of your life, no required minimum distributions on your Roth, and if you leave them to beneficiaries, they don’t have to touch it until the end of the 10th year after death, and when they take it all out, whatever it grows to, all income tax-free. That’s a great move for beneficiaries, for you to do for your beneficiaries, because by the time they inherit, they could be in their own highest-earnings years.

‘Tax Bracket’ vs. ‘Tax Rate’

Benz: True. One last question for you, Ed, is just kind of a terminology question related to tax bracket versus tax rate. So much confusion about what the difference is. Can you clear that up?

Slott: There’s something called your marginal rate: the rate you pay on your last dollar of income. So, you do get all the low brackets. You’re right, people mix that up all the time. They say, “Well, I’m in the 24% or 35% or 37%.” The 37% is the top bracket now. So, people hit the 37% bracket, think all of their money is taxed. It isn’t. You still get the lower brackets for each of those brackets. You only pay at the marginal rate, the top rate on your last dollar, for the amount that goes over into the 37% bracket. So, there’s a big difference. But you want to use up—the key to this section we’re doing here is to take advantage every year you can of these giant, expanding brackets that have currently very low rates. Getting more money—this money has to come out. It will be taxed. I’m talking about your IRA money. It’s not if, but when, kind of like death. It’s not if, but when, this money will be taxed. So as long as you know it’s going to be taxed, get it on sale.

Benz: Ed, it’s always great to get your insights. Thank you so much for being here.

Slott: Thank you.

Benz: Thanks for watching. I’m Christine Benz from Morningstar.

Watch How to Determine Your Expected Retirement Date for more from Christine Benz.