A Roth conversion is when an investor moves cash or investments from an IRA, 401(k), 403(b), SEP IRA, or SIMPLE IRA plan to a Roth IRA, Roth 401(k), or Roth 403(b).
Typically, tax is paid in the year of conversion. The benefit is that when account distributions occur down the road, these distributions are income tax-free.
It's an assumptive tradeoff with the goal of minimizing the overall tax burden over the life of a financial plan.
There are several factors to consider and no financial situation is the same as the next. Generic advice definitely doesn't apply with Roth conversions.
IT'S ALL ABOUT TAXES
Here's a simplified example of how the tax works. You have a $500,000 IRA and decide to convert 10% of it, or $50,000. Assuming you make $100,000 and that's your only source of income, a $50,000 conversion adds $50,000 to your income for a total of $150,000. Instead of paying ordinary income taxes on your $100,000 salary, you now pay ordinary income taxes on $150,000.
Assuming a married filing jointly tax status, an extra $50,000 of income equals an additional $11,000 in federal taxes owed.
Doesn't seem like a good deal at this point.
However, a $50,000 Roth IRA earning 7% compounds to $98,000 after 10 years and this entire amount is tax-free upon distribution.
If left in the IRA, that $50,000 grows to the same $98,000. But, all $98,000 is subject to taxation. Assuming a 22% federal tax bracket, you actually only have $76,440 because $21,560 is lost to taxation when distributions occur.
In this highly simplified hypothetical example, you paid $11,000 in taxes at the time of conversion to save $21,560 in future taxes.
Now it's a good deal.
If only conversion was as easy as I laid out in the section above.
There are many other factors potentially at play such as state taxes, the opportunity cost of investing that extra $11,000 you would've had if no conversion occurred, nondeductible IRA contributions living inside your IRA, and even what future tax rates may be.
Conversions can get complicated quickly.
If the considerations just mentioned didn't scare you off, let's map out some general scenarios when conversion may prove valuable.
According to FP Pathfinder, a financial planning checklist + flowchart service I subscribe to, there are a few guidelines to gauge whether or not a Roth conversion is beneficial. In general, consider conversion if:
Beneficiaries of your IRA/401(k) are not charities.
You're working and expect to be in a similar tax bracket in retirement or you believe tax rates will increase in the future.
You have cash outside your IRA/401(k) to pay the conversion tax.
You're not planning on taking distributions at least 5 years after conversion.
Taxable income is lower than normal due to scenarios such as time off between jobs, selling assets at a loss, retirement, or you have capital loss carryforwards from a previous year.
Your beneficiary kids are in a high tax bracket.
You're not close to the top of your federal marginal tax bracket.
The amount of conversion won't create an additional tax on Social Security payments if already claiming.
You're on Medicare and the amount of conversion won't push you over $176,000 ($88,000 for single tax filers) of modified adjusted gross income to trigger higher Medicare Part B & D monthly costs.
You're not receiving an advance premium tax credit on your health care if buy it on your state's or the federal exchanges.
These are general guidelines to follow. None of them on their own represent a reason to (or not to) convert. If you tick a lot of those boxes, then conversion is probably a valid strategy. Just be careful, the benefit of conversions is still assumptive in nature.
Also, the Tax Cuts and Jobs Act of 2017 axed the ability to "undo" conversions. Once an investor goes down the conversion road, there's no turning back as you're on the hook for the taxes owed.
THE MOST OVERLOOKED CONVERSION OPPORTUNITY
Despite the warnings just mentioned, retirees who exit the workforce prior to claiming Social Security are in a unique position to benefit from a Roth conversion.
Imagine you're in your 60's, recently retired, and haven't started taking Social Security. Your income and tax bill are low since you're paying expenses from cash at the bank plus distributions from your taxable investment account taxed at the 15% long-term capital gains rate.
In the client cases I've reviewed, the long-term tax benefits often outweigh the upfront conversion tax. We can model the numbers illustrating how conversion at this stage in life works.
In this chart, my hypothetical client retired at age 64. We're planning on the bulk of Roth conversions at ages 64 through 68. In this case, we targeted the additional income associated with conversions as close as possible to the 12% federal marginal bracket (reverts to 15% bracket at the end of 2025). These are the blue sections of the chart. Think about this strategy as filling up the 12% tax bracket "bucket".
You could apply the same tactic using the 22% bracket, or even the 0% capital gains bracket which tops out at $88,800 for married couples ($40,400 for single filers).
Assuming this hypothetical client takes the majority of their Roth IRA distributions near the end of the plan, $694,558 in total conversions result in $2,912,146 worth of future tax-free income.
$2.9M is a big number. However, this is the dollar amount projected at the end of the plan (age 95). Also, $2.9M in today's dollars is not the same as $2.9M three decades down the road after inflation eats up a chunk of the buying power.
Time is a critical factor to determine the additional value a conversion represents. The longer an investor has before taking Roth IRA distributions, the more compelling the case is to convert.
For example, if we revisit the hypothetical case above, at age 80 the Roth IRA balance is $1.4M.
The $1.4M in the Roth IRA represents tax-free income, but that same $1.4M left in the IRA loses $314,806 to taxation at ordinary income rates.
By age 80, this client spent $152,802 in taxes on conversions. Had they left assets in the IRA, they would've paid $314,806 in taxes on distributions on that same $1.4M.
The difference of $162,004 represents the value of converting.
An extra $162,004 could mean a few things, especially for investors with substantial Social Security and/or pension income.
It means that retirement spending can be increased, they could retire earlier than anticipated, donate more to clarity, or pass on more to their kids. All good options to have.
ROTH CONVERSIONS ARE COMPLICATED
Roth conversions should be thought out exercises focused on an investor's unique financial circumstances. Despite their complexities, Roth conversions can add a significant boost to a retiree's income.
My advice is to not assume Roth conversions are either beneficial or not.
Talk to an experienced financial planner familiar with this type of analysis. Do not rely on generic articles, even this one, you find online or anyone's opinion without crunching the numbers.
If you'd like to learn more about Roth conversions and if they could be beneficial in your scenario, feel free to shoot us a message using the "Contact" link in the upper right of this page to start a conversation.
For additional information, please continue your due diligence using these resources:
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