Should Federal Employees and Retirees Perform Roth IRA Conversions?

 

Many financial professionals are saying that the first six months of 2024 has created much uncertainty among investors. There is uncertainty as far as the direction of the national economy, the direction of interest rates, who will be in the White House on January 21, 2025, which political party will control houses of Congress starting next January, and what will happen to individual tax rates starting January 1, 2026 when the current low individual tax rates (a result of the Tax Cuts and Jobs Act of 2017 which is due to expire on December 31, 2025) expire.

One investment strategy that is picking up steam during this low individual tax rate environment is converting traditional IRAs to Roth IRAS. For federal retirees (and federal employees over age 59.5), some investment advisors recommend that these employees and retirees directly transfer a portion of their tradition Thrift Savings Plan (TSP) to traditional IRA and then convert the “rollover” traditional IRA to a Roth IRA. Note that a TSP participant cannot directly rollover a traditional TSP account to a Roth IRA. The traditional TSP account must first be directly transferred to a traditional IRA and then converted to a Roth IRA.

SEE ALSO:

• Recharacterization of Roth IRA Contributions
• Roth IRAs and Potential Estate Tax Savings

But converting a traditional IRA to a Roth IRA involves several considerations. Factors that can make a Roth IRA conversion a good or a bad investment move include:

(1) Age;

(2) Future income needs;

(3) Future retirement location;

(3) Availability of liquid money (cash) for paying the up-front tax bill that comes with a Roth IRA conversion; and

(5) Estate plans for bequesting traditional IRA and TSP retirement funds.

The uncertainty as to what federal individual tax rates will be (higher or remain at their current level) on January 1, 2026 is perhaps the biggest challenge when it comes to determining whether a Roth IRA conversion is a good idea during 2024 and 2025. This column takes a closer look at this uncertainty and other considerations in answering the question as to whether employees and retirees should perform Roth IRA conversions during 2024 and 2025.

What Is a Roth IRA and What Are the Benefits Associated with Roth IRA Ownership?

A Roth IRA is a retirement savings account that is funded with after-tax dollars. Qualified withdrawals from a Roth IRA are tax-free. Individuals whose modified adjusted gross income (MAGI) exceed certain limits are not permitted to contribute to a Roth IRA. In particular, for 2024 the MAGI limits are $146,000 for single or head of household tax filers and $230,000 for married couples filing jointly. Another example of an individual who cannot contribute to a Roth IRA for 2024 is an individual who already contributed the maximum amount allowed to a traditional IRA (a “deductible” or a “nondeductible” traditional IRA) during 2024 ($7,000 if under age 50 as of December 31, 2024; $8,000 if over age 49 as of December 31, 2024).

Fortunately, there is a workaround for individuals who are not eligible for one reason or another to contribute to a Roth IRA. This comes in the form of a Roth IRA conversion. A Roth IRA conversion allows an individual, regardless of the amount of the individual’s adjusted gross income, to convert all or part of an existing traditional IRA to a Roth IRA. Federal employees over the age of 59.5 and federal retirees are permitted to request a tax-free direct rollover of a portion of their traditional TSP account to a “rollover” traditional IRA (regardless of the TSP participant’s adjusted gross income). The “rollover” traditional IRA can then be converted to a Roth IRA.

In order to perform a conversion of a traditional IRA to a Roth IRA and/or to transfer of a portion of one’s traditional TSP account to a traditional IRA which is then converted to a Roth IRA, the traditional IRA owner or traditional TSP participant should consider several questions, including: (1) Is the IRA owner’s or traditional TSP participant’s marginal tax rate during 2024 and 2025 lower than what the traditional IRA owner’s/TSP participant’s effective tax rate will be at the time they withdraw their Roth IRA in retirement?; (2) Will the traditional IRA owner/traditional TSP participant need to withdraw the money from the Roth IRA within the next five years?; (3) Does the traditional IRA owner and traditional participant have a sufficient amounts of liquid assets (passbook savings, money market accounts) to pay in full all federal and state income taxes due during the year of the Roth IRA conversions?; and (4) Does the traditional IRA owner/TSP participant have any estate gifting intentions for the converted Roth IRAs?

While a Roth IRA conversion or traditional TSP transfer to a Roth IRA is not advantageous for everyone, there are several scenarios in which it may be to the IRA owner’s/TSP participant’s advantage.

The potential benefits of a Roth IRA conversion/traditional TSP transfer include: (1) Increased flexibility and tax diversification; (2) Roth IRAs do not have required minimum distributions (RMDs). Note that any converted/transferred amounts will not be included in the calculations for future traditional IRA and traditional TSP RMDs, possible lowering taxable income in the future; (3) A traditional IRA owner/traditional TSP participant can pay taxes now at historical low levels compared to income tax rates over the past few decades; and (4) Roth IRAs can give the Roth IRA owner increased flexibility for legacy and estate planning. In particular, higher income beneficiaries will not have to worry about mandatory Roth IRA distributions affecting their income tax liability.

But there are potential risks associated with a Roth IRA conversion, including: (1)Taxes have to be paid upfront at the time of conversion. Traditional IRA owners who want to convert their traditional IRAs to Roth IRAs or traditional TSP participants who want to transfer all or a portion of their traditional TSP to a Roth IRA need to weigh the opportunity cost of using funds now to pay the taxes due versus paying taxes later if they were not converting and simply making future withdrawals from their traditional IRA and traditional TSP accounts; (2) Federal and state income taxes could be lower in the future; (3)A traditional IRA conversion cannot be undone, a result of the Tax Cuts and Jobs Act of 2017; and (4) There may not be a long enough investing time horizon to make the conversion worthwhile. Note that Roth IRA conversions need time ( a minimum 5 to 10 years) for the earnings to grow to make up for the upfront taxes paid. If the Roth IRA owner needs the Roth IRA funds sooner than 10 years, a Roth IRA conversion does not make financial sense.

What Should Federal Employees and Retirees Interested in Making Roth IRA Conversions Do?

Anyone employee or retiree interested in performing a Roth IRA conversion during 2024 and/or during 2025 (either a conversion of an existing traditional IRA or a traditional TSP transfer to a traditional IRA which is then converted to a Roth IRA) is advised to speak with a tax professional. An informed tax professional can help with the proper tax strategy associated with a Roth IRA conversion. Most importantly, the tax professional should discuss with the employee or retiree the advantages and disadvantages of a Roth IRA conversion and in particular, whether a Roth IRA conversion is suitable for the employee/retiree. The SECURE Act (and SECURE Act 2.0) has made a Roth IRA conversion more complex and confusing for individuals to understand. There are many variables in which the outcome may be unknown.

Roth IRA Conversion Five Year Rule

“Contributory” Roth IRAs (Roth IRAs are funded via regular contributions); for example, federal employees whose MAGI limits during 2024 are below $146,000 (single employees) or $230,000 (married employees filing jointly) can contribute a maximum $7,000 to a Roth IRA plus an additional $1,000 for those employees aged 50 and older as of December 31, 2024). If an employee or retiree holds unto the first Roth IRA account he or she contributed to for at least 5 years, the employee or retiree can enjoy tax-free withdrawals of the Roth IRA earnings if the employee or retiree is over age 59.5 at the time of withdrawal.

There is a separate 5-year Roth IRA rule that determines whether the distribution of principal from the conversion of a traditional IRA to a Roth IRA is penalty-free. As with “contributory” Roth IRAs, the 5-year rule for Roth IRA conversions uses tax years, but the conversion must occur by December 31 of the year the conversion happens.

Each Roth IRA conversion has its own 5-year period, but IRS rules stipulate the oldest conversions are withdrawn first. The order of withdrawals for Roth IRAs are contributions first, followed by conversions, and then earnings. Any converted Roth IRA owner who takes a distribution of earnings within 5 years of the conversion will pay a 10 percent penalty on the earnings unless the converted Roth IRA owner qualifies for an exception. That means that if a federal employee or retiree performs Roth IRA conversions during 2024 and 2025, each conversion has its own 5-year clock.

Given the separate 5-year clock for each Roth IRA conversion performed during 2024 and 2025, federal employees and retirees who know for a fact that they will need to make withdrawals from a Roth IRA they converted during 2024 and 2025 are advised not to perform that Roth IRA conversion.

Inherited IRAs and Roth IRA Conversions

With the exception of a surviving spouse, any individual who inherits a traditional IRA during 2024 or 2025 cannot convert the traditional IRA to a Roth IRA. Surviving spouses who intend to convert an inherited traditional IRA from a deceased spouse should be aware that the conversion gets complicated when the inherited traditional IRA is composed of contributions that were made with after-tax dollars.

Increase in the Age for Taking Traditional IRA RMDs

The passage of the SECURE Act in December 2019 and SECURE Act 2.0 in December 2022 has boosted the age for traditional IRA owners to start taking their traditional IRA required minimum distributions (RMDs) (called the required beginning date or RBD) from age 70.5 to age 75 (currently age 73; will be age 75 starting January 1,2035). That means federal retirees who are below their RBD during 2024 and 2025 and probably in a low to middle federal marginal tax bracket. As such, locking in a low to middle marginal bracket during 2024 and 2025 by converting their traditional IRAs to Roth IRAs makes good sense as it will result in lower traditional IRA RMDs when they reach their RBD and subject to mandatory traditional IRA RMDs, likely resulting in future tax savings.