The tax-now Roth IRA will increase in popularity over the coming years. Let me explain why.
When Congress passed the Tax Cut and Jobs Act (TJCA) of 2017, it inaugurated an eight-year period of the lowest tax rates in American history, which started on January 1, 2018.
However, due to the sunset clause that was built into the legislation, the tax sale ends on December 31, 2025. If Congress does nothing, which they tend to do, taxes will revert to their pre-2018 levels on January 1, 2026.
Therefore, the logical solution is to try and convert some of your tax-deferred retirement money in your 401(k)s and traditional IRAs into a tax-now Roth IRA. This way, you can potentially save on taxes if tax rates are higher during your retirement than while working.
The question is how much of your tax-deferred retirement funds should you move?
Quick Historical Thoughts On The Roth IRA
I’ve been a long-time opponent of the Roth IRA since I haven’t been able to contribute to one since I turned 25 in 2002. The arbitrary income limits to be able to contribute shut me out.
In addition, doing a Roth IRA conversion wasn’t appealing after my income declined by 80% once I left banking in 2012. The last thing I wanted to do was pay more taxes. Instead, I wanted to hold onto as much money as possible to get through an unknown future.
However, now that I’m older with children, I now believe contributing to a Roth IRA is a good way to tax-efficiently diversify your retirement income sources. With the TJCA expiring on December 31, 2025, it’s worth focusing on the Roth IRA again.
How Much Tax-Deferred Assets To Shift To Tax-Now By January 1, 2026
To decide on paying taxes up front by contributing or converting assets into a tax-now Roth IRA, we need to make the following assumptions:
- Congress will let tax rates return to previous levels on January 1, 2026
- Tax rates may go even higher than pre-2017 levels due to an even larger budget deficit
- You believe your tax rates in retirement will be higher than your tax rates while working
Here’s the thing. For the vast majority of Americans, I do not think their tax rates will be higher in retirement than while working. As a result, the urgency of shifting assets from tax-deferred retirement accounts to tax-now accounts is low.
Also, please don’t be fooled when financial advisors or books refer to the Roth IRA as a “tax-free” retirement vehicle. How can a Roth IRA be tax-free when you have to pay taxes before contribution? A Roth IRA is a tax-now retirement vehicle.
Yes, once you make your after-tax contributions to a Roth IRA, the growth compounds tax-free, and the withdrawals after five years are tax-free. But there is no free lunch when it comes to the government.
The only way Roth IRA contributions are tax-free is when you earn below the standard deduction limit and contribute. So for those of you who are working students, working part-time, or just starting your careers, opening up a Roth IRA makes a ton of sense.
The Average American Retirement Tax Profile
We know the median retirement balance is around $100,000. We also know the median Social Security payment is around $24,000 a year.
Even if you withdraw $10,000 a year from your median retirement balance a year, your total income would be $34,000 ($24,000 + $10,000). That income falls within the 12% marginal federal income tax rate, which is low. It seems unlikely the 12% tax rate and income threshold of $44,725 for 2023 will go lower.
Therefore, one could argue the average American in the 12% marginal federal income tax bracket should contribute as much as they can afford to a Roth IRA. After all, the next tax bracket jumps by 10% to 22%, the largest tax jump of all the tax brackets.
No Tax Increases For The Middle Class
Given we know politicians crave power the most, we also know raising taxes on middle-class Americans will cause politicians to lose power. Hence, there is virtually zero chance politicians will raise taxes on any person or household making less than $100,000.
I doubt politicians will raise taxes on people making under $250,000 either. President Biden has already promised the public he won’t raise taxes on Americans making less than $400,000. So a $150,000 income buffer is more than enough to feel protected from future tax hikes.
Of course, nobody knows the future of where tax brackets will go. All we know is the long-term tax bracket trend is down since the 1950s. And once you start giving people what they want, they are loathed to give up what they have.
The Mass Affluent American Tax Profile
Now let’s say you have been a regular Financial Samurai reader since 2009. As a result, 33% of you have an above-average income of between $100,000 – $200,000. 18% of you make over $200,000 a year, while 17% of you make between $75,000 – $100,000 a year.
You also have an above-average net worth. 35% of you have a net worth of between $300,000 – $1 million. 25% of you have a net worth over of $1 million.
With such an income and wealth profile, the majority of you will face the 24% and 32% marginal federal income tax rates. For individuals, the income range is $95,376 – $231,250.
For those in the 32% marginal income tax rate, it makes little sense to convert any funds to a tax-now Roth IRA. You will unlikely pay an equal or higher marginal income tax rate in retirement.
32% Marginal Federal Income To Contribute To Tax-Now Roth IRA
Let’s assume you make $182,101, the lowest income threshold that begins to face a 32% marginal federal income tax rate. At a 4% withdrawal rate, you would need $4,552,525 in capital to generate $182,101 in retirement income.
Even if you collect $40,000 in annual Social Security, thereby lowering your income threshold to $142,101, you’d still need $3,552,525 in your retirement accounts to start paying a 32% marginal federal income tax rate in retirement.
Now let’s assume you make $231,250, the highest income threshold that pays a 32% marginal federal income tax rate until you face the 35% rate. At a 4% withdrawal rate, you would need $5,781,250 in capital to generate $231,250 in retirement income.
Even if you collect $40,000 in annual Social Security, thereby lowering your income threshold to $191,250, you’d still need $4,781,250 in your retirement accounts to match your working income and pay a 32% marginal federal income tax rate.
Yes, I firmly believe the vast majority of personal finance readers will retire millionaires. But it is unlikely the majority of mass affluent personal finance readers will retire with over $3.55 – $4.8 million in capital plus $40,000 in annual Social Security payments in today’s dollars.
Again, it is highly unlikely tax rates are going up for those making less than $250,000 a year. A 32% marginal federal income tax rate is already 10% higher than what the median household income of $75,000 faces.
The 24% Marginal Federal Income Tax Profile Is A Wash
If your income taxes are likely not going up making $250,000, then there’s even a greater likelihood your income taxes are not going up if you make less.
Making between $95,736 to $182,100 (24% marginal income tax bracket) as an individual provides for a comfortable middle-class lifestyle, depending on where you live in the country. At this income range, you are a highly coveted group of voters. I would even go as far as to say you are untouchable.
$182,100 is also what I consider to be the best income to live the best life and pay the most reasonable amount of taxes.
Here’s the thing. If you make $95,736 on average as a worker, it won’t be easy to amass $2,393,400 in retirement by 60 at a 4% rate of return to generate $95,736 in retirement income. Remember, the median retirement balance is only around $100,000.
Even with $25,000 a year in Social Security, you’d still need $1,893,400 in retirement to generate $70,736 a year at a 4% rate of return.
Therefore, for most workers in the 24% marginal federal income tax bracket, the most likely best-case scenario is a PUSH. Meaning you will pay the same tax rate in retirement as you did while working.
The Standard Deduction Will Help Push Your Retirement Tax Bracket Lower
Even if you pay off your mortgage and lose all your itemized deductions in retirement, you will still benefit from the standard deduction to reduce your taxable income.
The standard deduction for married couples filing jointly for tax year 2023 rises to $27,700 up $1,800 from the prior year. For single taxpayers and married individuals filing separately, the standard deduction rises to $13,850 for 2023.
In other words, as an individual, you could actually make a gross income of $58,575 and remain in the 12% marginal tax bracket even though the 22% marginal tax bracket starts at $44,766. $58,575 gross income minus $13,850 standard deduction equals $44,765.
In 20 years, at a 3% annual increase, the single taxpayers standard deduction will rise to $25,000 and the married couples filing jointly standard deduction will rise to $50,000.
The 10% And 12% Marginal Federal Income Tax Profile Is Ideal For Roth IRA Contribution
If you ever find yourself in the 10% and 12% marginal federal income tax bracket, then by all means contribute to a Roth IRA or conduct a backdoor Roth IRA conversion.
Let’s say you are a young worker paying 10% or 12%. You likely have income upside to pay a higher rate in the future. If you’re fortunate enough to pay a 0% marginal federal income tax rate thanks to the standard deduction, shovel as much money as you can into a Roth IRA!
You are contributing tax-free money, enjoying the benefits of tax-free compounding, and will get to withdraw the money tax-free as well. In this case, the Roth IRA truly is tax-free.
If you are an older worker who finds themselves underemployed or out of a job one day, converting some money to a Roth IRA or contributing makes sense.
Losing Income Makes Contributing To A Tax-Now Roth IRA Difficult
In my experience, it’s just hard to pay taxes to fund a Roth IRA when you’re out of a job or aren’t earning as much as you once were.
In 2013, I earned the least amount of money since 2003. My severance check was paid out in 2012 and I no longer had a paycheck. Therefore, I should have converted some of my 401(k) money into a Roth IRA.
Instead, I just rolled it over into a traditional IRA because paying taxes on my retirement savings was last on my list. I was still coming to grips with what I had done – leaving a well-paying job at age 34.
There was also a point in my post-retirement life when I wanted to be a fruit farmer in Oahu. If so, I’d have plenty of years paying a low marginal tax rate to convert some funds into a Roth IRA.
Alas, my income bounced back because my investments rebounded from the global financial crisis. Further, Financial Samurai grew and random opportunities such as startup consulting and writing a book came about.
Higher Taxes Are Not Guaranteed Beyond 2026
I first wrote, Disadvantages Of A Roth IRA in 2012, during the Obama administration. The post engendered a lot of dissension, which I had expected. The majority of commenters said taxes rates are only going up.
Then Trump became president and the Tax Cut and Jobs Act was passed in 2018. As a result, tax rates went down. Therefore, anybody who contributed to a Roth IRA or converted funds to a Roth IRA during the Obama administration made a suboptimal financial decision.
Given we now have the lowest tax rates in history and a clear December 25, 2025 expiration date, it is now safer to assume tax rates are going up. It’s the same thing as assuming interest rates were likely to go up in 2020 given the 10-year bond yield dropped to 0.56%. At the very least, we didn’t buy bonds.
Today, we are happily buying Treasury bonds yielding 5%+. So maybe shifting more assets from tax-deferred to tax-now retirement vehicles is good for retirement income diversification.
Roth IRA distributions do not have any Required Minimum Distributions. Further, our itemized deductions in retirement tend to disappear after we pay off our mortgages.
Count On Politicians To Keep Tax Rates Low
The path of least resistance is to do nothing, which Congress is great at. We also need to raise more tax revenue to pay for our massive spending since the pandemic began. Therefore, the probability that tax rates go up beyond 2026 is the highest it’s been in a while.
However, I’m also counting on all politicians’ desire for power. When you have power, you are loathed to relinquish it.
It’s like elite colleges holding onto legacy admissions. Colleges know the legacy admissions system rigs entrance for the wealthy majority. But elite colleges would rather abandon SAT/ACT requirements in order to have more leeway in determining their incoming classes.
Hence, I assign only a 20% probability that tax rates are going up in 2026 for sub $250,000 income-earners. For those households making over $400,000, the probability that tax rates are going up in 2026 is likely over 70%.
We could see occasional temporary spikes, as we did with inflation in 2022 and 2023. However, over the long run, raising taxes is political suicide.
As always, consult a tax professional before making any moves.
Related post: Use Rule 72(t) To Withdraw Retirement Funds Penalty Free
Reader Questions And Suggestions
Do you think tax rates are going up in 2026? If so, are you actively contributing or converting money from tax-deferred to tax-now retirement vehicles? What do you think is the breakeven tax rate for contributing or converting to a Roth IRA?
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