We are reading a lot about if, when, and how people who have conventional IRA accounts should be evaluating whether to convert them to Roth accounts. For those who don’t live in this world, let’s take a minute to bring you along. IRA accounts are account you established while working for your retirement. When you put the money into the IRA, the government allowed you to exclude that contribution from your income for tax reporting purposes. But lest you think you got away with something, an IRA account allows your deposit to grow tax free until the day you begin to tap it for expenses. When you do relent and draw on the account you pay income tax on the amount you draw at ordinary income tax rates. Do it before age 59.5 and Uncle Sam will typically bang you for an additional 10% early withdrawal penalty on top of the regular tax.
The amounts you could contribute were not big. In 1975 when the program started it was capped at $1,500 a year. Today it is $6,000. So, assume you put $2,000 in IRA index fund in 2000. And let’s use Vanguard as the model. Today that $2,000 is worth $9,600 because it increased by 380%. You are now easily 59.5 so there will be no penalty on withdrawal. But understand that if you take the $9,600 you are going to pay ordinary rates on that. Let’s also assume you are still employed and making $150,000 in 2024 as a single person. Your standard deduction is $14,600 so your taxable income will be $135,400 before you pull the taps on your IRA. You are in a 24% marginal bracket at that point which means that if you take your $9,600, the government will want $2,304 and leave you with $7,296.
Now we will throw a curve at you, but for a reason. Let’s assume you are getting divorced. Technically you are still married and there are differences between how couples are taxed from single people. But, let’s also assume that your spouse is working but making only $30,000 a year. Again, we will assume a single standard deduction and that is also $14,600 so her taxable income is $15,400. Her tax rate on the same $9,600 IRA withdrawal would be half your rate or 12%. On the same withdrawal she gets to keep $8,448 a savings of $1,152 just based on who made the draw.
All the published articles we have been reading talk about the benefits of conversion to a Roth IRA. A Roth account is one where you take the money out of its tax sheltered status (i.e., regular IRA) and pay the tax on the withdrawal so that you can roll the net of the funds (net of taxes) into a Roth plan. Once in the Roth plan, you don’t pay taxes on any future withdrawals. It grows tax free. There are lots of little rules affecting this and they warrant a visit to your accountant to make certain you don’t run afoul of them. The consequences of that could be big.
When you and spouse are planning your divorce you have a $100,000 of IRA money that could be converted to a Roth. But if you did that your taxable income rockets to $235,400 because you are tapping the IRA to make a Roth contribution. Most of that $100,000 will be taxed at 24% but $43,500 is subject to tax at 32%. To be precise $56,550 gets hit for 24% and $43,550 is hit at 32%. In a word your “conversion” will cost you $27,492. Roughly 27.5% of the pot.
Now, suppose you got cagey and transferred the $100,000 to your spouse in the divorce. So long as the transfer is direct from your IRA to her IRA there is no tax due. Now, what she does is convert half of her new IRA to a Roth in 2023. Her taxable income for 2023 will be increased by the $50,000 and come in at $65,400. Her tax on that is $9,441. The tax on the rollover itself is partially at 12% and partially at 22%.
On January 2, 2024, she awakens and goes to the bank and takes the remaining $50,000 out of the IRA to convert to a Roth. Assume she then resumes working at $30,000 a year. Unless brackets are changed her tax for 2024 will be the same as 2023. She will have taken $100,000 of money and put it into a tax free growth account. On her $100,000 conversion, her actual tax will be $15,650, leaving her with $84,350. Had you kept the IRA and done the same your tax would be $37,538. Giving her the IRA money in the divorce is money that is much more valuable in her hands than in yours.
Two forces are at work here. The first is that her tax bracket is much lower than yours. That’s an instant savings of federal tax. The second is that by splitting the conversion over two tax years you avoid driving her income into more highly taxed brackets. And, in practical terms you actually are getting the split done in less than 90 days although the split is in two separate tax years.
Under the Rule of 72 money invested at 6% doubles every 12 years. If you did the conversion and bought a 12 year bond, you would have $124,924 when it matured. She would have $168,700 just because she was taxed at a much lower rate on the conversion.
The articles I have read talk about consulting your financial planner. My own thought is this is better directed by your accountant because that person will have a better gauge on your tax brackets in the conversion years. Once you convert to a Roth then circle back to the financial planner to decide how to best grow your now tax-free money.
The Roth conversion is appealing but you need to consider the rate of tax which will be applied to the amount you are converting. That requires an understanding of marginal tax rates. Here they are for 2024 but understand that you don’t want to get this transaction wrong. That’s why an accountant can be of help. The rate table: https://www.nerdwallet.com/article/taxes/federal-income-tax-brackets#2024%20tax%20brackets
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