The SECURE Acts Make Roth IRAs More Attractive

The passage of the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 and the SECURE 2.0 Act of 2022 has made Roth individual retirement accounts (IRAs)—and other Roth retirement accounts—more attractive for many investors.

Let’s start with investors who have yet to reach the required beginning date (RBD) for taking required minimum distributions (RMDs). Effective this year, the starting age for taking RMDs is now 73. It was 72 last year and 70½ prior to 2020. The RBD will rise to age 75 in 2033.

Those who retire before age 73 (or 75) may experience a period before reaching their RBD when their tax rates will be much lower than they were in their working years. This creates a window where dollars held in tax-deferred accounts like a traditional IRA or 401(k) can be rolled over into a Roth account at reduced tax rates. The advantage to doing so will be to avoid the potential triple whammy of having RMDs increase your marginal tax rate, your Medicare premiums and the amount of Social Security benefits that are taxable.

Wade Pfau explains such a strategy in the July 2023 issue of the AAII Journal.

Though it was possible to take advantage of this reduced tax rate window prior to the passage of the original SECURE Act of 2019, the window of time for doing so is now wider. The longer time frame allows you to convert even more dollars to a Roth IRA. The calculation includes figuring out what your tax rate will be once your RMDs start (including state taxes, which may or may not apply to RMDs) and your ability to pay the taxes on the conversion. The goal is to save enough on combined future taxes and Medicare premiums to justify incurring the tax hit now.

Those intending to leave sizable inheritances should consider the likely tax rate of their heirs.

Inheriting a sizable IRA could lead to years when the marginal tax rate of your heir(s) is increased. This isn’t the case with inherited Roth IRAs, where the distributions aren’t taxable. The simplistic comparison is your marginal tax rate plus any additional Medicare premiums you will pay (assuming 85% of your Social Security benefits are already taxed) versus the expected tax rate of your heir(s). If your tax rate is lower, it may make sense to do the conversions while you are able to.

The rules regarding inherited IRAs should be taken into consideration before making this decision. (Other estate planning issues may also play a role, making speaking to an estate planning professional a prudent step for some.)

The SECURE Act requires withdrawals from inherited IRAs to be taken over a 10-year period. The starting date can be delayed if the heir is a minor child (but not a grandchild) up to majority age, or if still in school up to age 26. Disabled individuals [as recognized by the Internal Revenue Service (IRS)], chronically ill individuals and individuals not more than 10 years younger than the IRA owner are also exempt from the 10-year rule. Once an heir no longer qualifies as an eligible designated beneficiary, they are subject to the 10-year rule.

Surviving spouses can make their deceased spouse’s IRA their own, thereby avoiding the 10-year rule. Inheriting a tax-deferred account will increase their future RMDs and thereby future taxes and Medicare premiums.

The new surviving spouse designation, which goes into effect next year, is also a consideration. It allows the surviving spouse to be treated as if they are the employee and they do not need to take distributions from the deceased spouse’s plan account [e.g., a 401(k)] until the employee would have reached their RBD for taking withdrawals.

This rule does not appear to apply to Roth 401(k)s and Roth 403(b)s as RMDs will no longer be required to be taken by the account owner starting in 2024.

One other way Roth IRAs are now more attractive involves education savings. The SECURE 2.0 Act allows balances of up to $35,000 in a 529 college savings plan to be converted to a Roth IRA. This allows dollars saved for but not spent on educational expenses to be turned into retirement savings. These savings can continue to grow tax free, and withdrawals can eventually also be taken on a tax-free basis.

To qualify, the 529 plan must have been funded for at least 15 years ending on the date of distribution, the amount must not “exceed the aggregate amount contributed to the program (and earnings attributable thereto) before the five-year ending on the date of the distribution” and the rollover must be made via a “direct trustee-to-trustee transfer to a Roth IRA maintained for the benefit of such designated beneficiary.”

Are there cases when a traditional IRA, 401(k) or other retirement account funded with pretax dollars still makes sense? Yes. It doesn’t make sense to do a Roth IRA conversion when you are in a high tax bracket and expect to be in a lower tax bracket in the future. If you don’t expect your tax rate to change significantly in retirement, then the advantages of doing a Roth conversion diminish (though it is still worth working through the numbers). A third case is if you need to withdraw additional dollars from your tax-deferred retirement accounts beyond the amount to be converted to cover the extra taxes. Finally, a conversion that pushes you above marginal tax rate, credit and/or deduction thresholds in the current year or Medicare premium thresholds two years in the future may not make financial sense.