Important considerations when converting a Traditional IRA or TSP Account into a Roth IRA
With less than six months remaining in the year, federal employees and annuitants still have time to save on federal and state income taxes over the long term by converting some of their traditional IRAs to Roth IRAs and/or transferring a portion of their traditional TSP accounts to Roth IRAs. While there is an immediate tax liability when performing a Roth IRA conversion and transferring a portion of one’s traditional TSP account to a Roth IRA, the cost of paying the taxes due now could be relatively small when compared with the future benefits. This column discusses these future benefits and some of the important considerations that employees and annuitants should think about before performing a traditional IRA conversion or traditional TSP transfer to a Roth IRA.
Some Reasons Why Paying Taxes Now Rather Than Later Makes Financial Sense
The primary reason behind paying taxes today rather than in the future is that the taxable amount of the traditional IRA converted or the amount of the traditional TSP transferred to a Roth IRA will likely be taxed at a lower rate now than it would be in the future if no conversion or transfer were performed and taxes would then be paid upon the withdrawal of the traditional IRA and/or traditional TSP account. That presumption of higher individual tax rates likely in the future comes as a recent change in the tax laws. The Tax Cuts and Jobs Act of 2017 (TCJA) lowered individual tax rates starting Jan. 1, 2018, and continuing through Dec. 31, 2025. Effective Jan. 1, 2026, individual tax rates will revert back to their higher 2017 rates, inflation-adjusted.
Moreover, it is quite possible that a federal employee’s income could be higher once the employee has retired from federal service, especially because the annuitant will be receiving Social Security retirement monthly benefits, CSRS or FERS monthly annuity benefits, and TSP distributions. The higher income amounts in the future are most likely for those employees who have more than $1 million in their combined traditional TSP and traditional IRAs, as well as any income coming from 401(k) and 403(b) qualified retirement plans that the annuitant previously participated in. There are many current and future federal annuitants who are, or who will be, facing a five-figure required minimum distributions (RMDs) starting when they are age 72 and beyond.
There are other benefits besides possible tax savings when traditional IRAs are converted to Roth IRAs. Roth IRAs are not subject to RMDs while the Roth IRA owner is alive. Future earnings grow tax-free. Also, assuming a qualified Roth IRA withdrawal is made, Roth IRA withdrawals are not included in adjusted gross income and do not count for purposes of what an individual pays for Medicare Part B each year. Medicare Part B is a “means-tested” program, meaning that the higher an individual’s adjusted gross income (AGI), the more the individual pays for Medicare Part B each year. Traditional IRA and traditional TSP RMDs for individuals over age 72 are included in AGI.
Finally, a bonus of a Roth IRA conversion is that Roth IRA beneficiaries inherit a pre-funded Roth IRA upon the death of the Roth IRA owner. While a non-spousal beneficiary has to take RMDs (based on their life expectancy), the distributions will be tax-free. Once again, converting a traditional IRA or transferring the traditional TSP to a Roth IRA makes sense if the tax rate on conversion is lower not than what it would likely be if and when the heirs receive the traditional IRA and/or traditional TSP and take the RMDs from those accounts, paying income taxes at their marginal tax brackets.
When and How Much Should Be Converted and/or Transferred to a Roth IRA?
The best time to perform a traditional IRA conversion or to transfer a portion of one’s traditional TSP to a Roth IRA is the time in which the tax rate on the conversion or as a result of the transfer is most likely lower than the tax rate at which future withdrawals would be taxed. Often that occurs in the year shortly after a federal employee retires but before he or she starts receiving Social Security and makes withdrawals from his or her TSP account. Ideally, retired employees will be receiving a sufficient CSRS or FERS annuity (so as to not have to tap into any other retirement accounts or receive Social Security retirement benefits) in order to pay all living expenses while performing these conversions and transfers.
In addition, a recently retired employee must have a sufficient amount of liquid assets (that is, passbook savings, money funds) in order to pay the federal and state income taxes due resulting from a Roth IRA conversion or transfer from the traditional TSP to a Roth IRA. The taxes due cannot be withheld from either the converted IRA or the traditional TSP.
In terms of how much can be converted or transferred to a Roth IRA, the key amount to convert from traditional IRAs to Roth IRAs and/or transferring a portion of one’s traditional TSP account to a Roth IRA in any given year is an amount that will not result in the IRA owner being pushed into a higher marginal tax bracket. For 2021, the 12 percent federal marginal tax bracket stops at $40,125 for a single filer and $80,250 for married couples filing jointly. Any taxable income above those amounts is taxed at 22 percent until the taxable income (which includes the amount being converted or transferred) increases to $85,525 and $171,050, respectively. Any taxable income above those respective amounts will be taxed at 24 percent until the next limits at which time the 32 percent bracket begins. Those individuals over age 70.5 who must take RMDs from their traditional TSP and their traditional IRAs cannot convert their RMDs to Roth IRAs. But they can convert amounts over the RMD figure to Roth IRAs.
Employees and annuitants are highly encouraged to work with their tax advisors in order to develop an optimum conversion and transfer strategy. When there is around one month remaining in 2021, employees and annuitants have a better handle as to their anticipated 2021 taxable income. Perhaps this month would be a good time to perform a Roth IRA conversion or for employees over age 59.5 to transfer a portion of their traditional TSP to a Roth IRA. Under the new TSP withdrawal rules, employees over age 59.5 can make up to four “age-based” traditional TSP transfers to Roth IRAs, while retired employees can make up to 12 such transfers per year.
Some Consequences of Roth IRA Conversions
Adding taxable income (such as a Roth IRA conversion and transfer of the traditional TSP to a Roth IRA to an individual’s tax return could trigger some unintended consequences besides additional federal and state income taxes. Perhaps the most significant consequence is those federal annuitants who are enrolled in Medicare Part B could see an increase in Medicare Part B premiums during 2021 as a result of additional income received in 2021. That being said, even those annuitants and employees not enrolled in Medicare Part B at this time should wait this month to make any conversions until any mutual funds held in unsheltered accounts distribute all of their year-end dividends and capital gains.
There is also the net investment income (NII) tax of 3.8 percent that is imposed on investment income including taxable interest, dividend, and capital gain income when an individual’s modified adjusted gross income (MAGI) (AGI less the foreign earned income exclusion) exceeds certain limits as shown in the following table:
Net Investment Income Tax MAGI Thresholds
|Filing Status||3.8% surtax1 imposed |
when MAGI exceeds2
|Married Filing Jointly, Qualified Widow||$250,000|
|Single, Head of Household||$200,000|
|Married Filing Separately||$125,000|
1The 3.8% tax is imposed in addition to the regular tax due on investment income
2These amounts are not adjusted for inflation
Converting a large amount of a traditional IRA to a Roth IRA or transferring a large amount of the traditional TSP to a Roth IRA during a particular year could result in an individual’s MAGI exceeding the threshold amount and having to pay the NII tax in that year.
Moreover, the calculations to perform a Roth IRA conversion are more complex and require more precision than in previous years. Unlike pre-TCJA, traditional IRA owners cannot “recharacterize” (undo) a Roth IRA conversion performed during 2021 before the 2021 income tax return filing deadline of April 15, 2022. This means that any Roth IRA conversion performed during 2021 will be counted as taxable income and included on the 2021 federal and state income tax returns. It has always been true, and continues to be true, that a transfer of a portion of one’s traditional TSP to a Roth IRA cannot be “undone” and the portion transferred will be included in current year income. For 2021. It is therefore imperative that federal employees and annuitants who are considering a Roth IRA conversion and/or transfer of the traditional TSP to a Roth IRA seek professional tax advice as soon as possible in order to make the correct decision of proceeding with a conversion or transfer during December 2021.
*Unless certain criteria are met, Roth IRA owners must be 59½ or older and have held the IRA for five years before tax-free withdrawals are permitted. Additionally, each converted amount may be subject to its own five-year holding period.
Edward A. Zurndorfer is a Certified Financial Planner, Chartered Life Underwriter, Chartered Financial Consultant, Chartered Federal Employee Benefits Consultant, Certified Employees Benefits Specialist and IRS Enrolled Agent in Silver Spring, MD. Tax planning, Federal employee benefits, retirement and insurance consulting services offered through EZ Accounting and Financial Services, and EZ Federal Benefits Seminars, located at 833 Bromley Street – Suite A, Silver Spring, MD 20902-3019 and telephone number 301-681-1652. Raymond James is not affiliated with and does not endorse the opinions or services of Edward A. Zurndorfer or EZ Accounting and Financial Services. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. While the employees of Serving Those, Who Serve are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional.