Anytime the tax code changes, it presents opportunities (or challenges) that might not have existed before, and this time around, with the One Big Beautiful Bill Act (OBBBA), it is no different. Fortunately, it is a little easier to navigate the new code because there were no direct changes to the basics we are used to with IRAs, 401(k)s, Roths, or other usual retirement accounts. Still, there are plenty of factors that indirectly affect the decisions one might make with those accounts.
Roth Conversions and OBBBA
One area that is garnering more attention is Roth conversions. These have always been an attractive option under the right circumstances, and even before OBBBA, they were becoming a household term for many people, not just financial advisors.
In your Traditional IRA or 401k, you get a tax deduction when you put money in. It grows over time, and then you are taxed at ordinary income rates whenever you eventually withdraw the funds. The benefit of a Roth is that it is tax-free in the future. You do not get a tax deduction when you put the funds in, but down the road, after years of growth, the withdrawals are entirely tax-free (with minimal exceptions). Roth conversions are when you choose to take the funds in a Traditional pre-tax account and convert it over to Roth, thereby paying the taxes now, but ensuring your future withdrawal of those funds and all associated growth is tax-free. The effect of a large pool of tax-free funds on your financial plan cannot be understated. It’s a powerful strategy that can improve a financial plan or potential future inheritance, but to do it effectively requires a good understanding of your financial and tax situation.
Every situation is different, and Roth conversions are not necessarily something everyone should do. However, it’s my belief that OBBBA opens the door a bit wider for more people to benefit from the strategy.
What Changed with OBBBA
- The most significant change was actually no change at all. The lower income tax rates and higher standard deduction we have had since 2017 will remain the same, which is by far the most significant factor in Roth conversions. The basic logic for making a conversion is that you expect the tax rate you pay today to be lower than the rate you would pay in the future. While the rates are “permanent,” we all know that’s a loose term when it comes to modern politics. Consider the national debt, it stands to reason that higher tax rates will eventually be necessary (with increases likely to hit higher-income individuals the hardest). There is no crystal ball or perfect science to tell us what tax rates will be in the future. However, many are comfortable paying the tax now at current rates to reduce the risk of future tax increases.
- OBBBA offers a new deduction of $6,000 for individuals 65 or older ($12,000 for a married couple both 65 or older). The deduction applies whether you itemize or take the standard deduction. It would make sense to consider this an invitation for a married couple to use this deduction specifically to convert $12,000 to a Roth and have a substantially similar overall tax bill to that in prior years, all else being equal. Beware, however, because this deduction phases out between $75,000 and $150,000 for single filers, and between $150,000 and $250,000 for joint filers. The phaseout limits present the risk of a ‘tax torpedo’ since additional income (from a Roth conversion, for example) would not only create additional taxable income but also reduce the deduction that you can take, effectively meaning every new dollar of income in that range could trigger additional taxable income of more than a dollar.
Another consideration is the huge, but temporary, increase in the State and Local Tax (SALT) deduction. Since the 2017 tax changes, this has been capped at $10,000 (even for married couples), leading many people to take the larger standard deduction, rather than itemize. Now with OBBBA, the cap on SALT deductions is expanded to $40,000 for tax years 2025 through 2029. Similar to the deduction above, this presents the opportunity to do a Roth conversion of whatever your new itemized deduction amount is and remain in the same place tax-wise. Again, beware of the tax torpedo, because the $40,000 deduction phases out above $500,000, so conversions above that amount are not only taxable themselves but also reduce the amount of SALT deduction one could take.
Like everything else in financial planning, Roth conversions and the impact of the new tax laws are situation-specific. There is no one-size-fits-all rule that can be applied across the board. If you have questions about whether Roth conversions are beneficial to your financial plan, please consult your advisor. If you have tax-specific questions, please consult with a tax professional.