Is high inflation a good time for Roth IRA Conversions?
Posted on July 19, 2024
I read this article at Morningstar last week, “Is high inflation a good time for Roth IRA Conversions?” It argues that “when it comes to taxes, inflation is great.” As the start of marginal tax brackets increase “more funds can be passed through lower tax brackets.” “Your tax bill becomes lower.” This logic is incorrect and stems from not “thinking real” – failing to think what is happening to dollars with the same spending power. When you think real, you’ll realize that inflation has no effect on the amount of tax we pay and does not provide a better opportunity to convert traditional IRAs to Roth. I cite three best times to convert traditional to Roth: inflation isn’t a factor.
Details:
== Think real ==
Let’s look at the effect on inflation on the taxes we pay in terms of dollars with the same spending power:
Assume you have the same real income over two years. Assume inflation was 10%: and your income is the same in real spending power but is 10% greater in dollars: think that all income rose in line with a 10% COLA for Social Security. The Standard Deduction, the start of the marginal tax brackets therefore the cumulative tax owed at the start of each bracket adjust for inflation each year. Let’s assume they increased by 10%.
When you work through a tax return, you find the total taxes that you pay increase by 10% in dollars in the second year but is the same real amount as the first year. Your net after taxes is unchanged in real spending power.
And as I mentioned in this post, inflation is definitely not a friend of taxpayers at the lower income levels. A greater percentage of their Social Security income is taxed because the base amount not subject to tax does not adjust for inflation. This also pushes taxable income toward the point where dividends and capital gains are taxed at 15% rather than 0%.
It’s a mixed bag for the rest of us who already max out at 85% of Social Security that is taxed. The Standard Deduction and tax brackets adjust using Chained CPI-U, and that typically is lower than several other measures of inflation. I might argue that over time we actually pay a shade more in tax on the same real amount of income.
== Best time for Roth conversions ==
You’d like to convert at a lower marginal rate than you will face in the future and convert the greatest percentage of your traditional IRA that you can. I list three “best” times: inflation isn’t part of the equation.
1. Convert traditional to Roth when your marginal tax rate is lower than you think it might be in the future.
You always want to convert if you are in the 12% marginal tax bracket, and you really can’t go wrong by converting at the 22% marginal rate.
I argue that your lowest effective tax rate when retired is greater than 22% – closer to 25%. The 10% and 12% marginal tax brackets are a myth because of the way Social Security is taxed. The 22% and 24% marginal brackets are effectively about 2 percentage points greater because of Medicare Premium surcharges (IRMAA) that hit folks with that level of income.
If you and your spouse project to a very large RMD, you may want to convert at 24% marginal tax rate to avoid the jump to the 32% rate that the surviving spouse might pay: the 32% rate for a single filer starts at half the amount for married, joint filers.
2. Convert earlier, not later:
• Convert before you start on Medicare. You can convert much more since you don’t have to to worry about triggering Medicare Premium surcharges (IRMAA).
• Convert before you have to take your RMD. The income from RMD limits your room to convert at the 22% rate and still avoid an IRMAA tripwire.
• Convert early when your IRA is smaller. The same real dollar amount will convert a greater percentage of your traditional IRA. At expected rates of return, your traditional IRA may double in real spending power in a decade or so. The same real amount converted later bites half the percentage it would have if converted earlier.
3. Convert when the value of your traditional IRA nosedives. The most recent low point for the value of US stocks was October 2023. Deciding to convert traditional to Roth was probably the last thing on our mind then, but $10,000 in the same spending power converted then would have been a 50% greater percentage than now: the inflation-adjusted value now is 50% greater than it was then.
Conclusion: A recent Morningstar article implied that inflation is good for us in terms of taxes that we pay. That’s simply not true, and is clear to see when you “think real” – removing the distortion and confusion that creeps in when we don’t inflation-adjust. Because all the important items for taxes adjust for inflation each year, we basically pay the same real amount of tax on the same real amount of income over time.
The article implied that inflation provides a greater opportunity to convert traditional IRAs to Roth. There are better opportunities to convert, but periods of high inflation is not a factor. I site three in this post:
1. You are never hurt if you convert and stay in the 22% marginal tax bracket – you will never pay a lower effective tax rate you are retired;
2. Convert early – before you are on Medicare or are subject to RMD and when your IRA is smaller;
3. Convert when the value of your traditional nose dives.