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| 2023 tax rates for a single taxpayer (federal income tax rates in the United States are the same for 2023 and 2024) |
Scenario: Your taxable income is $12,000, placing you in the 12% tax bracket.
Options:
- You could contribute more to a retirement account, thereby reducing your taxable income to below $11,001.
- Alternatively, you could perform a Roth conversion, pushing your taxable income up to the upper limit of $44,725.
Weighing Roth Conversion vs. Traditional Contribution
Here's a breakdown of the pros and cons for each option considering the potential sunset of favorable tax rates in 2025 and the benefits of Roth IRAs:
Option 1: Traditional Retirement Account Contribution
Pros:
- Lower your tax bill for 2024: This will put more money in your pocket now.
- Tax-deferred growth: Your contributions and earnings grow tax-deferred within the account.
Cons:
- Tax on withdrawal: When you withdraw the money in retirement, you'll pay income tax at your then-current tax rate.
- RMDs: After reaching age 72, you'll be required to take minimum withdrawals (RMDs) from your traditional IRA, which can push you into a higher tax bracket.
- Future tax rates: If tax rates increase in the future, you might end up paying more in taxes than you would now.
Option 2: Roth Conversion
Pros:
- Lock in today's potentially lower tax rate: By converting to a Roth IRA, you pay taxes on the converted amount now at the current (potentially lower) rate. This guarantees tax-free withdrawals in retirement regardless of future tax rates.
- Tax-free withdrawals: Qualified withdrawals from a Roth IRA, including both contributions and earnings, are tax-free in retirement.
- No RMDs: Unlike traditional IRAs, Roth IRAs don't have required minimum distributions (RMDs). You can leave the money growing tax-free and withdraw it as needed in retirement.
- No limits: While there are income limits on Roth contributions, there have been no such limits for Roth conversions, making this a popular strategy for high-income investors.
- Higher tax bill for 2024: Converting to a Roth IRA will increase your taxable income for 2024 and potentially put you in a higher tax bracket this year.
- Reduced access to funds in the short term: The converted amount becomes locked in the Roth IRA and subject to contribution withdrawal rules (penalty-free access to contributions only) until you reach retirement age (59 ½ with a 5-year holding period).
Choosing Between the Options
The best option depends on your individual circumstances and risk tolerance. Here are some factors to consider:
- Your age: If you're young and have a long time horizon until retirement, the tax benefits of a Roth IRA can be more significant due to the potential for tax-free growth over a longer period.
- Your expected future tax bracket: If you believe tax rates will be higher in retirement, a Roth IRA conversion can be advantageous by locking in the potentially lower current rate.
- Your current and future financial needs: Consider if you need immediate access to the funds. Traditional IRAs offer more flexibility in this regard.
- Considering a Roth conversion before moving? If your new state taxes retirement income more (e.g., moving from Texas to California), converting now can save on future taxes.
Conclusion
While knowing the tax rate range is a good starting point, tax planning can get complex. Consider consulting a tax professional for personalized advice based on your specific financial situation.
