Converting a traditional IRA to a Roth IRA has many advantages, but it can result in a hefty tax bill. The solution? A bracket-topping Roth conversion.

Traditional IRA vs Roth IRA

The primary advantage of a traditional IRA is that all contributions are tax-deductible. No taxes are due on the money placed into a traditional IRA. Taxes are due in retirement when distributions are made.

The primary advantage of a Roth IRA is that no taxes are due on retirement distributions. Taxes are paid on contributions when they are placed into a Roth IRA.

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Which is better? A Roth IRA. The reason is simple. With a Roth IRA, investment earnings are never taxed.

The whole point of investing your retirement savings is to make them grow. If it’s done right, your savings can double or more. All investment earnings are taxed with a traditional IRA, but no investment earnings are taxed with a Roth IRA.

Briefly, Roth IRAs have two other advantages over traditional IRAs: no Required Minimum Distributions, and the possibility of lower tax rates. Required Minimum Distributions are government-mandated account withdrawals beginning at the age of . Regarding tax rates, our ever-increasing national debt has many financial professionals believing future tax rates will be higher. If that is true, paying taxes now with a Roth will result in overall tax savings. 

Bracket-Topping Roth Conversion

A bracket-topping Roth conversion is spread out over a number of years, each year converting only the amount that does not bump you into a higher tax bracket.

There are seven federal income tax rates: 10%, 12%, 22%, 24%, 32%, 35% and 37%. In general, the more money you earn, the higher your tax rate. However, the relationship is not linear. Tax brackets are just that; income brackets bounded by upper and lower limits. As long as your income remains within a specific bracket, your tax rate remains the same.

For example, for the 2023 tax year (brackets are adjusted each year for inflation), the 22% tax bracket for married couples filing jointly is $83,551 to $178,150. If your taxable income is $84,000, your tax rate is 22%. If your taxable income is $178,000, your tax rate is still 22%. That’s a pretty broad range, which is exactly what a bracket-topping Roth conversion seeks to exploit. 

A Roth conversion is a taxable event, meaning taxes are due in the year it occurs. If you convert a sizable traditional IRA to a Roth IRA, it can easily push you into a higher tax bracket. Not only will you pay taxes on the entire Roth conversion in a single year, but you will pay them at a higher rate.

A bracket-topping Roth conversion requires you to calculate the amount of “headroom" in your tax bracket. Then you convert only that amount or less each year. To find your headroom, simply subtract your taxable income from your tax bracket upper limit.

Bracket-Topping Roth Conversion Example

Bob and Mary are married and they file taxes jointly. They are in the 22% tax bracket and their taxable income is $100,000. They want to convert a $250,000 traditional IRA to a Roth IRA but know that doing so in a single year will push them into a higher tax bracket.

Based on the 2023 married filing jointly 22% bracket upper limit of $178,150, they calculate they have $78,150 of headroom ($178,150 - $100,000 = $78,150). To be safe, they decide to limit each year’s conversion to $70,000. They do that every year until they have converted the entire $250,000. The last year’s conversion amount will be less than $70,000 ($250,000 - $70,000 - $70,000 - $70,000 = $40,000). 

It takes Bob and Mary 4 years to complete the Roth conversion. In the first three years when they are converting $70,000, they add $15,400 to their tax bill (0.22 x $70,000 = $15,400). 

Conclusion

Without professional guidance, a bracket-topping Roth conversion might seem like an impossibly complex task for mere mortals to achieve. It’s really not. I recently helped a family member do a bracket-topping Roth conversion and it worked out beautifully. 

Admittedly, I used the bracket-topping Roth conversion feature in Eggstack to assist with the calculations, but everything went off without a hitch. She ran it by her tax accountant and he said everything looked good.

You too can accomplish this seemingly impossible feat. Imagine how proud you will be telling your friends you’re doing a bracket-topping Roth conversion.

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