Who should consider doing Roth conversions
Roth conversions have been a hot topic for a while amongst advisors and consumers alike. However, figuring out if Roth conversions make sense - and how much to do - is a frustratingly difficult question to answer. That’s because it’s impossible to quantify the potential value, if any, to ultimately be realized by conversions, as it requires either a working crystal ball or going far into the future and having the benefit of hindsight to see how things actually played out.
In this article, I’m going to give common scenarios of where it could make sense for someone to consider doing Roth conversions. Notice I didn’t say will make sense, but instead said could make sense. That’s because there are rarely black and white situations where it’s 100% indisputable that doing conversions WILL ultimately be beneficial in its eventual tax savings. However, there are scenarios where, in my opinion, the chances of ultimately benefitting are better than not, and perhaps the potential amount of benefit is larger, too.
What is a Roth conversion?
First let’s start with what a Roth conversion is. In a nutshell, a Roth conversion is simply transferring money or securities from a traditional tax-deferred retirement account to a Roth version of a retirement account, and paying tax in the year of the transfer on the value of pre-tax money or securities converted.
Traditional tax-deferred retirement accounts include IRAs, 401(k)’s, 403(b)’s, 457’s and the federal Thrift Savings Plan, or TSP. The traditional flavors of these accounts are such that your contributions into them are tax-deferred, meaning the amount of money you put into them is not taxed in the year of the contribution. Instead, you pay income tax on any money you eventually take out of them. In that sense, all of these accounts are basically just not-yet-taxed income, hence whey they’re called “tax-deferred” or “pre-tax” accounts.
The benefit of contributing money to traditional pre-tax accounts is that the contributions lower your taxable income in the year of the contribution. For example, if you have $100k of gross wages this year, and contribute $10k to your traditional pre-tax 401(k), your taxable income for the year will only be $90k; not $100k. Therefore you’ll have a lower total tax obligation for the year as a result of making that contribution.
While money is in the pre-tax account and invested, any gains or income on the investments is tax-deferred as well. In other words, you’re not taxed on your gains or income in the year they occur. Like I mentioned above, you’re not taxed until you eventually distribute money out of the account. At that point, any pre-tax money you take out will be included in your gross income that year, and taxed at ordinary income tax rates.
On the other hand, a Roth version of an IRA, 401(k), 403(b), 457 or TSP has the opposite tax characteristics of their pre-tax counterparts. The money you put into a Roth account does NOT get a tax-deferral, hence there is no reduction in taxable income in the year of making the contribution. Said another way, contributions to Roth accounts are after-tax.
The benefit of a Roth account is that all distributions are eventually income tax-free, assuming you meet certain qualifying conditions (the most common of which is that you’re at least 59 ½ AND you first funded your Roth account at least five years prior). Also, like with traditional retirement accounts, you’re not taxed on gains or income in the Roth account along the way; all such gains and income are tax-deferred until you eventually take money out of the account. But again, the goal is that you eventually meet the qualifying conditions before taking withdrawals of gains or income, thus qualifying all distributions to be tax-free.
Why consider doing Roth conversions?
So, why consider doing a Roth conversion? Recall that money in a pre-tax retirement account is essentially just not-yet-taxed income. When you contributed money to the account, you didn’t avoid tax on the money you contributed; you simply opted to defer the realization of taxation on that money (and any gains thereon while inside the account). In other words, you didn’t get rid of the tax obligation on that money, but instead just kicked the tax down the road to be paid later.
With that in mind, doing a Roth conversion is consciously deciding to recognize the taxation of some of the income within a pre-tax account now, by transferring money from a pre-tax account to a Roth account and paying tax on any pre-tax money that was transferred/converted. And then whenever money is eventually withdrawn from the Roth account, it will all be tax-free (again assuming you meet the qualifying conditions at the time of the withdrawal).
With that said, doing a Roth conversion is in effect deciding to no longer kick the tax can down the road, but instead deal with it now, by paying tax on however much pre-tax money you decide to convert. And then all subsequent growth on that money inside the Roth account will eventually be tax-free, whereas if the money had stayed in the pre-tax account, all growth on it would eventually be fully taxable as ordinary income when withdrawn from the account.
And that is the overarching reason why someone would consider doing Roth conversions: because they think they’ll be paying less tax on the money now by converting it than they otherwise would in the future if they leave it in the pre-tax account and eventually distribute it from there.
As such, the “to convert or not to convert” question boils down to figuring out when you’ll pay less tax on the money; now or in the future (whenever that may be).
While that question is simple on the surface, it’s impossible to answer with accuracy. It’s easy enough to know the present-day tax impact of doing a conversion, as you can simply do a tax return projection for the current year with all of your other income and deductions and such, and then add the conversion to it and see what the incremental tax would be on the conversion.
But trying to nail down the projected tax impact of instead leaving the money in your pre-tax account and distributing it in 5, 10, 20, etc. years in the future is nothing more than educated guessing, at best.
The amount of tax you’ll have to pay on eventual pre-tax distributions depends on multiple future factors whose future values can’t possibly be known with certainty now, such as:
- Future tax rates and the dollar amounts of income at which each bracket will start and stop
- The future amount of your other sources of income such as dividends, interest, Social Security, required minimum distributions from pre-tax accounts, capital gains, etc.
- The future amount of your deductions and miscellaneous tax credits
- Whether you’ll be a single or married tax return filer in the future (maybe you’re single now, but will be married in the future, or vice versa)
The above things are the known unknowns; we know they will play into how much tax we ultimately have to pay in the future, but we can’t possibly know at this point what their precise impacts will be in the future.
As if they known unknowns not already hard enough to know, there will also be unknown unknowns, such as new provisions of the income tax code that don’t currently exist but may come into place by the time you’re taking your pre-tax account distributions in the future.
For example, the additional 3.8% Net Investment Income Tax, or NIIT, on passive investment income over $200k (if single) or $250k (if married) of gross income didn’t exist prior to 2013. It was a brand new addition to the tax code that year, as part of the Affordable Care Act.
What if there is a brand new additional tax like the NIIT that gets built into the tax code between now and the future? There is no way to account for something like that now, as we don’t even know what it might look like, when it might apply, how much it might be, etc.
And, to make matters even more difficult and seemingly hopeless with regards to trying to guess what your future income tax situation might look like, there are other stealthy and indirect taxes that could come into play.
For example, there are income-based Medicare premium surcharges known as Income Related Monthly Adjustment Amounts, or IRMAA. There are currently five different levels of surcharges, where the higher your gross income, the higher your surcharge.
While these Medicare premium surcharges aren’t directly a tax, per se, they’re practically a tax and should be considered as such, in my opinion. Anytime you have to pay more for something because your income is over a certain level, that’s functionally a tax in my mind. And, like actual taxes, these Medicare surcharges are subject to legislative changes. Who knows what they’ll look like in 20+ years when you’re taking distributions from your pre-tax accounts.
By doing Roth conversions and realizing income tax today (and any related knock-on or indirect taxes that might apply such as the NIIT or IRMAA surcharges, as a result of the higher income from the conversion), you are inherently saying you believe that the total amount of direct and indirect tax you’ll be paying on the conversion now will be less than whatever total tax you’d otherwise be paying in the future if you were to leave the money in a pre-tax account and eventually distribute it from there.
And I should add that when I say “total tax” today vs in the future, I actually mean the effective percentage tax on the conversion (and any related direct or indirect taxes as a result of the conversion).
If your effective tax rate in the future will be truly identical to what it is now, this whole analysis is mathematically a push, even though the total dollar amount of tax to be paid in the future will likely be larger by leaving the money in the pre-tax account.
For example, assume you are considering converting $10,000 today, and that you’ll pay an effective tax rate of 20% on it. Your total tax bill on that conversion would be $10,000 * 20% = $2,000. Which means, after paying tax, it’s only $8,000 of money that will actually go into your Roth IRA and get invested.
Let’s assume that money will double in 15 years. At that time, you will then have $16,000 in your Roth IRA, all of which can be distributed completely tax-free (assuming you meet the aforementioned qualifying criteria).
Let’s instead assume you didn’t convert the $10,000 and left it in your pre-tax account. We’ll again assume the money doubles in 15 years. At that time, it will be worth $20,000. However, you’ll have to pay tax on it, because remember pre-tax accounts are really just big pots of not-yet-taxed income; you have to pay the piper when you finally distribute money.
We’ll assume your effective tax rate in 15 years will be the same 20% as it is today. Which means if you fully distribute that $20,000 from your pre-tax account in the future, you’ll have to pay $20,000 * 20% = $4,000 tax on it.
Notice the total dollar amount of tax in that scenario is larger the $2,000 that you could have paid today in doing the Roth conversion. BUT, after paying that $4,000 of tax in 15 years, your net after-tax money would be $16,000…the exact same that you would hypothetically have in your Roth account if you went the Roth conversion route.
With this example in mind, don’t pay attention to just the dollar amount of taxes to be paid today vs in the future. You have to compare the effective tax rates (again including the impacts of any other direct or indirect taxes that result from doing the conversion).
If you know your effective tax rate in the future will be higher than it is today, Roth conversions likely make sense for you. Conversely, if you know your effective tax rate in the future will be lower than it is today, Roth conversions likely do not make sense for you.
Sounds simple, right? But the problem is, as previously discussed, there is no way to actually know what your effective tax rate will be in the future. So the best we can do is make educated guesses.
Don’t get too hung up on all of this
Now that you know how difficult (i.e. impossible) it is to figure out how much tax you can potentially save by doing Roth conversions, hopefully it makes more sense why I started this article by saying there are some scenarios where it could make sense and be of future benefit for someone to do conversions. Some people’s situations and circumstances are such that they have a greater chance of being in a higher income tax situation in the future than they are currently. For such folks, Roth conversions make more sense as they can potentially be of greater tax savings.
With that framing in mind, I think it’s important to think about Roth conversions in the sense of getting the directionality of the decision right, without worrying about trying to quantify the exact amount of potential benefit you might get from it. In other words, focus more on figuring out could conversions be of benefit while focusing less on how much could that potential benefit be.
Also, it’s important to know that the whole conversion topic is really just an optimization exercise. Conversions (or lack thereof) won’t make a good plan bad, or a bad plan good. They could potentially make a good plan a little better, or a bad plan a little less bad. But they definitely won’t make or break your plan.
There are a few big boulders in the retirement planning world that can truly make or break a plan. Such as not having enough saved for the level of spending you plan on needing (or, viewed another way, spending too much for the amount actually saved). Or investing 100% of your portfolio in some super concentrated high-risk investment. Or giving no considerations to the non-financial side of retirement, such as figuring out what you’ll do for meaning, purpose and a sense of fulfillment.
If you don’t properly plan for these big boulders, you run a much higher risk of an unsuccessful retirement. But whether you do Roth conversions or not, the ultimate outcome of your plan likely won’t change materially from what it otherwise would have been. So don’t sweat it too much, and don’t overthink it (which is admittedly easy to do!)
When might Roth conversions make sense
Finally…now I’ll get to the part you’ve all been waiting for. Here are some scenarios where considering Roth conversions could make sense:
You know your income now is much lower than it will be in the future
Recall I said a few times that there is no way to know with certainty what your tax situation or effective tax rate will be in the future. However, there are times when it’s virtually certain that it’s lower now than it will be in the future; potentially ever again!
A typical example is in the years after you stop working and you therefore no longer have income from wages. And perhaps you haven’t yet started Social Security or your pensions (if you have one). And perhaps you aren't yet of Required Minimum Distribution, or RMD, age and don’t need to take distributions from your pre-tax accounts yet.
If this is the case, it’s possible your only sources of taxable income are really small. Such as just some bank account interest and maybe some dividends from a brokerage account. Once you start Social Security, for example, your income will permanently be higher for the rest of your life. As such, the low income period you’re in now may be the lowest income (and tax bracket) you’re ever going to have.
For example, assume you were making $200k per year in wages but recently retired at 65 years old. Further assume you decided you won’t start Social Security until age 70, when your projected benefits will be $60k per year. Between now and then, assume your only income will be $10k from bank account and CD interest and about $5k from dividends in a brokerage account…that’s it…$15k of total income.
Once you start Social Security, your income will jump materially. Therefore, between now and then, you’re in the lowest income situation you’ll ever be in for the rest of your life. This could be a great opportunity to intentionally pull forward the realization of income and taxation on some of your pre-tax account balances; while you’re in a really low tax bracket that you might not be in ever again once Social Security starts in a few years.
For example, maybe you’re only in the 10% tax bracket now. But when Social Security starts, you’re projected to be in the 22% bracket (or whatever the brackets might be at the time. Again, we don’t know exactly what the bracket will be in the future, but it’s almost certainly going to be higher than it is now considering how small your income is currently).
You’re married (and may eventually be single)
Spouses typically name each other as the primary beneficiaries of their retirement accounts. Which means when the first spouse dies, the surviving spouse generally gets the deceased spouse’s accounts and makes them their own.
This means that the surviving spouse will likely have as much pre-tax account money as the two spouses had combined prior to the other spouse dying. That in an of itself isn’t a problem. But the change in tax brackets in going from married to single likely will be problematic.
Married couples who file a joint tax return pay less tax on a given amount of income than single people do. That’s because the dollar amounts at which each tax bracket starts and stops are larger for married couples than they are for single people. Additionally, the standard deduction is double for married people vs single people.
When a surviving spouse inherits a deceased spouse’s pre-tax accounts, the surviving spouse will generally have approximately the same dollar amount of Required Minimum Distributions (which are taxable income) as the couple did combined when both spouses were alive. But the surviving spouse will have substantially compressed/lower tax brackets and smaller deductions, all else equal, compared to when both spouses were alive. This means that the surviving spouse will be paying more tax on the same amount of pre-tax account distributions.
To help minimize the effective increase in taxes for the surviving spouse in this scenario, the couple may consider doing Roth conversions while both spouses are still alive, and hence they have larger tax brackets.
By intentionally paying more tax now than they otherwise would have to, they can potentially save more than that in future taxes by minimizing the amount of pre-tax account distributions the eventual surviving spouse will have to take and be taxed on.
You have large pre-tax accounts
“Large” is admittedly very subjective. But I feel like I know it when I see it.
All else equal, the larger your pre-tax account balances are, the more taxable income you’re eventually going to have from taking distributions from those accounts.
If you only have $50k of pre-tax account balances, you don’t really have much of a big future tax liability on your hands. If, on the other hand, you have $5 million of pre-tax money, that’s a lot of not-yet-taxed income you’re going to have to distribute and realize at some point.
However, account size alone doesn’t answer whether you should convert or not. You have to also consider other factors. Such as the rest of your income and if that may be higher or lower in the future, like I mentioned before.
For example, if you’re still working and making $500k per year, doing Roth conversions probably isn’t the best move, as you’re already in the 30-something percent federal tax bracket. But if you plan on retiring next year and otherwise won’t have much income (like I mentioned before), maybe next year would be a good year to start working on trimming down that large pre-tax account balance with some conversions.
Your eventual heirs are likely to be in higher tax situations than you are currently
If you know you are “overfunded” in your retirement and are likely to leave sizable amounts of money to your heirs, you can consider who’d pay less tax on your pre-tax accounts; you while you’re alive, or your heirs after you’re gone.
For example, assume you have $1 million in a pre-tax IRA and you don’t plan on actually needing that money. You’ll have to take Required Minimum Distributions and pay tax on them during your lifetime. Otherwise, you don’t need to take out any more during your life. And let’s assume you’re currently in the 24% tax bracket.
What if your beneficiaries on that account are your adult kids, both of whom are in high paying careers and are likely to continue to be high earners for the rest of their working years. We’ll assume they’re in the 35% tax bracket.
With that in mind, if you do Roth conversions now, you’ll be paying 24% tax (disregarding any state income tax aspects for now). Or, if you die and leave the money to your kids, they’ll be paying 35% tax on it (again disregarding any state income tax considerations).
If you know the bulk of that pre-tax account will eventually be going to your kids, it could make sense for you to pay tax on it while you’re alive - by converting at least some of it to a Roth account - as opposed to leaving it for your kids to pay tax on after you’re gone - by leaving it as a pre-tax account and letting them inherit that.
Inherited pre-tax accounts generally have to be fully distributed within 10 years when children inherit accounts from their parents. And all pre-tax distributions your kids take will be taxed at whatever ordinary tax brackets they’re in. That could be a lot of tax they’ll have to pay if they’re in their peak earning years.
On the other hand, inherited Roth accounts are generally completely tax-free to heirs.
So, in this sense, wanting to be as tax efficient as possible in eventual wealth transfer could be a good reason to consider doing Roth conversions.
You plan on moving to a state that will have higher income taxes than your current state
Recall that the overall analysis of whether to do Roth conversions or not is based on trying to figure out if your income will be taxed at a lower rate now or in the future. And, if it would be taxed lower now, conversions can make sense.
As you now know, it’s really hard (i.e. impossible) to figure out what your precise tax situation will be in the future. However, certain things about the directionality of your future situation are somewhat straightforward to know. Such as if you’ll be moving and you’re going to a state whose income tax rate is higher than in your current state.
As an example, assume your total income between Social Security and pension is currently $100k per year. And that’s the extent of your income for now. And you know that level of income is never going to be any lower than it is now, because your Social Security and pension won’t be going away during your lifetime. Which means any distributions you eventually take from your pre-tax accounts will be additional income on top of the $100k of income you’ll already have each year.
Let’s assume you currently live in a state that does not have personal income tax, such as Florida or Texas. And, for whatever your reasons are (maybe you’ll be moving to be close to kids or grandkids, for example), you’ll be moving in a few years to a state that does have personal income tax. And let’s assume that state has a flat income tax rate of 5%.
All else equal, you know that any pre-tax account distributions you take in a few years will have 5% more income tax on them than they would if you took them now while you’re still in an income tax-free state.
Doing some conversions before you move to the new state could make sense, because you know you’ll be saving that 5% of income tax by converting now vs paying tax on distributions later.
You’re convinced tax rates will increase markedly in the future
I was reluctant to add this point, because it’s pure speculation. But it’s nonetheless an important point of consideration for many people.
Some folks are convinced that federal tax rates will have to increase dramatically in the future, to help reduce or at least stall the growth of our national debt. And such folks may think they’ll eventually be in a tax bracket as high as 50% or more.
In that case, even if they’re in a 30-something percent bracket now, they may find comfort in doing conversions today because they think they’ll be avoiding getting taxed at 50% or more on that money in the future.
While I don’t personally think most people have to worry about seeing such a dramatic rise in their tax rates, I obviously can’t prove something like that can’t happen.
So, all things considered, the more conviction (i.e. conviction in your speculation) you have about tax rates having to increase dramatically in the future, the more potential comfort and value you might get from doing Roth conversions.
You want greater tax “diversity” amongst your investable accounts
Many folks have the majority of their investable assets in traditional pre-tax accounts. This is common, as lots of people consistently plowed all of their retirement savings into their pre-tax workplace retirement plans on the assumption that they’ll be in a lower tax bracket in retirement than they are in their working years.
For many folks, that can indeed end up being true. But, particularly for the most diligent of savers, they often find themselves having really large pre-tax accounts when they enter retirement. And once they start learning about things like RMDs, Medicare surcharges, the Net Investment Income Tax, the progressive way in which Social Security is taxable, etc., they sometimes wish they had their money more spread around different account types like Roth accounts and normal brokerage accounts. Because they realize they might not actually be in a lower tax bracket in retirement than they were when they were working.
If all of your money is in traditional pre-tax accounts, you basically have no control over how future tax and legislative changes may impact your money and how much of your future distributions you actually get to keep after taxes. Simply put, every dollar taken out of your pre-tax accounts will be included in your gross income, and therefore subject to being taxed AND potentially triggering off other ancillary taxes like Medicare surcharges.
Doing Roth conversions can be a way to help diversify the future taxability of your investable assets. If instead of having all of your money in pre-tax accounts you instead also have some in Roth accounts, you will have better control over which accounts you pull your income from in the future, and therefore how you will be taxed (if at all) on those distributions.
Consider money in a Roth account as a hedge against the unknown of future taxes; regardless how bad or how high your future tax situation might be, you know that the amount of money in your Roth account will always be tax-free (again assuming you meet the qualifying conditions for tax-free distributions). While you can’t quantitatively put a number on what that value is, there is peace of mind value in it, if nothing else.
This list of scenarios when to consider doing Roth conversions doesn’t capture every possible scenario. However, it covers the majority of them. So I hope you find this helpful.
And you’ll notice I didn’t get into how much you should convert; I only mentioned when conversion could potentially be beneficial. Deciding how much to convert in total – across multiple years – is a hard thing to figure out. Because there isn’t a right answer, per se. But, if you decide conversions make sense for you, it’s at least a little easier in deciding how much to convert in any given year, because there will generally be some black and white income targets that you’re trying to limit yourself to, such as filling up the 24% tax bracket without dribbling over into the 32% bracket, staying below the level of income where Medicare surcharges would start, staying below the level of income where the Net Investment Income Tax would start etc.
Getting into the specifics of those things, and figuring out how much to convert in any given year, is beyond the scope of this month’s article. But maybe I’ll cross that bridge in a future edition!