Roth Conversions with the New Deduction

Take-Away: The new deductions in the recent tax bill signed into law, along with their phaseout rules, can negatively impact a planned Roth conversion.

Senior Tax Deduction: The new tax legislation creates a $6,000 tax deduction for individuals over the age of 65 years, or $12,000 per married couple, aka the senior deduction. However, from $150,000 to $250,000 of modified adjusted gross income [MAGI]  a phaseout of this new income tax deduction occurs; the senior deduction can be reduced to zero because of this phaseout.

Impact on Roth Conversions: The phaseout of the senior deduction can create a threshold issue for Roth conversions. At $150,000 of MAGI, this senior deduction for a married couple is $12,000, resulting in tax savings $2,640. While a $100,000 Roth conversion would generate a federal income tax liability of $22,000 at a 22% rate, the actual result is an increase of federal income tax of $24,640, not $22,000, with the difference being the loss of the senior deduction due to the increase in reportable MAGI caused by the Roth conversion amount.

SALT Deduction: Roth conversions are subject to both state and federal income taxes. Since 2018 state income taxes have largely been non-deductible when the SALT deduction was limited to $10,000. With the new tax law, the SALT deduction was increased to $40,000. The new $40,000 SALT deduction reduces the effective state and federal combined tax rate, which thus increases the efficacy of Roth conversions for some individuals. If planning a serial Roth conversion plan over several years, it would be wise to consider limiting Roth conversions in such a way to avoid exceeding the $40,000 SALT limitation per year. Just like with the senior deduction, this new SALT deduction should be isolated and looked at to determine whether it benefits the efficacy of a Roth conversion.

Impact on Roth Conversions: Along with the beneficial increase in the SALT deduction, there comes yet another phaseout problem. The phaseout of the SALT deduction starts with those individuals with income over $500,000. This deduction is subject to a phaseout of 30% of modified adjusted gross income (MAGI) over $500,000. At $600,000 of MAGI the SALT deduction will be reduced to a statutory floor of $10,000. Thus,  the phase-in kicks in and the SALT deduction is reduced from $50,000 to $10,000. [$600,000 – $500,000 = $100,000 X 30% = $30,000.]

Example: Fred and Ethel have MAGI of $500,000, with itemized deductions of $75,000 including their tentative SALT deduction of $40,000. Fred executes a Roth conversion of $100,000 of his traditional IRA. That Roth conversion increases Fred and Ethel’s reported MAGI to $600,000. But now, their SALT deduction is reduced to the statutory floor of $10,000 due to the additional income derived from the Roth conversion. While Fred and Ethel increased their reportable income by $100,000 with Fred’s Roth conversion, their reported taxable increased by $130,000. If Fred and Ethel were in the marginal federal income tax bracket of 35%, their effective tax rate on the increase from $500,000 to $600,000 of MAGI is 45.5% [35% marginal rate X 130% = 45.5%.] In short, this hidden 10.5% tax rate increase might eliminate most, if not all, of the benefits of the contemplated with Fred’s Roth conversion.

Conclusion: This is not to say that no one should consider a Roth conversion after these new income tax deductions. Not at all. Rather, when determining the benefits of a Roth conversion, now must be factored in the impact of the new senior deduction and the increase in the SALT deduction, or more accurately the impact of their phaseout rules. These deductions enhance the opportunity of a Roth conversion, but their phaseouts may put at risk larger Roth conversions for high earners.

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