Roth conversions are a financial planning tool that allows you to better control your lifetime tax burden. In this post, we will take a deep look at Roth conversions and what to consider in evaluating them for your situation.
Traditional vs. Roth IRAs
Before exploring Roth Conversions, it’s important to understand key differences between Traditional and Roth IRAs.
- Traditional IRAs are funded with pre-tax money, grow tax-deferred, and withdrawals are taxed as income.
- Roth IRAs are funded with after-tax money, grow tax-free, and withdrawals are tax-free.
Deciding whether to contribute to a Traditional IRA or Roth IRA is primarily based upon your current tax bracket and your estimated tax bracket in retirement.
- If you believe you are in a higher tax bracket today than you will be in retirement, then Traditional contributions are appropriate. You want to make pre-tax contributions (reducing your taxable income today) and pay taxes in retirement at a lower tax rate.
- If you believe you are in a lower tax bracket today than you will be in retirement, then Roth contributions are appropriate. You would want to make after-tax contributions (paying taxes today) and withdraw money tax-free in retirement, avoiding the expected higher tax rate.
What is a Roth Conversion?
Different than contributing directly to a Roth IRA, a Roth Conversion converts Traditional IRA assets to Roth IRA assets. (You may also be able to convert Traditional 401(k) assets to Roth 401(k) assets depending on your 401(k) plan provisions.)
The "cost" of this conversion is your current marginal tax rate. As we noted, Traditional IRA contributions are made with pre-tax dollars, but withdrawals are taxed as income. When you convert assets from a Traditional IRA to a Roth IRA, this is considered a withdrawal and you will be assessed taxes on the conversion amount in the year of the conversion.
For example, if you convert $50,000 from your Traditional IRA to your Roth IRA and are in the 22% marginal tax bracket, you will owe $11,000 in tax ($50,000 * 22%).
Benefits of a Roth vs. Traditional IRA
Although tax-free growth and withdrawals are the main benefits of Roth IRAs compared to Traditional IRAs, a few other benefits are worth mentioning.
1. Tax-free Growth and Withdrawals
The main benefit of Roth IRAs is tax-free growth and withdrawals. Dividends, interest, and capital gains are not taxable within a Roth IRA and after you reach age 59 ½ withdrawals are tax and penalty-free.
Although you pay taxes on the front-end, you are the sole investor in your Roth IRA and reduce uncertainty around future tax rates. Compare this to a Traditional IRA, where the government is participating alongside you, takes its cut when you make withdrawals, and may change tax rates in the future.
2. No RMDs (Required Minimum Distributions)
Traditional IRAs allow you to defer taxes until you make withdrawals. However, you cannot defer withdrawals and taxes forever. At a certain point, the government requires you to start taking withdrawals (Required Minimum Distributions (RMDs)) and paying taxes on your tax-deferred savings.
As of 2022, at age 72 you must begin taking RMDs from your tax-deferred accounts according to the uniform lifetime table. If you have built significant assets in your tax-deferred accounts, these RMDs can significantly increase your income and tax bracket.
Roth IRAs do not have RMDs because you have already paid taxes on your contributions.
3. Tax-free Inheritance
Roth IRAs are passed tax-free to your heirs while Traditional IRAs are taxable to your heirs (at their tax rate).
If inheritance is important to you, understanding your tax rate compared to your heirs is a valuable consideration.
Should I consider a Roth Conversion?
The efficacy of Roth Conversions is highly specific to your situation and assumptions about your future, so it is impossible to provide a simple yes or no. But here is a framework for evaluating a Roth conversion:
1. Total your Traditional IRA and other tax-deferred Qualified Assets (401(k), 403(b), 457, etc.)
Add up the current market value of your Traditional IRAs (including SEP, SIMPLE IRAs) and other tax-deferred retirement accounts.
2. Estimate the future value of these assets at RMD age (currently 72)
Use a future value calculator to estimate the value of these assets at age 72. The key inputs will include the present value (step 1), annual contributions, investment return, and years until age 72.
For example, if you are 32 (40 years to age 72) with $200,000 in tax-deferred retirement accounts, plan to make annual contributions of $20,000 at the beginning of each year, and expect a 6% return, you would anticipate $5.3 million at age 72.
Already we are making several assumptions about the next 40 years, and this calculation is very sensitive to these assumptions. The assumed rate of return is especially impactful. For example, changing the interest rate assumption from 6% to 8% in the example above increases the future value to $9.9 million.
Longer time periods, greater annual contributions, and higher investment returns will increase the expected future value and make Roth conversions look more attractive. Using more conservative return assumptions will mitigate the risk of inflating the value of Roth Conversions for your situation.
3. Determine anticipated RMD using Uniform Lifetime Table
RMDs are calculated based on the total balance of your tax-deferred accounts on December 31st of the previous year, divided by a life expectancy factor from the uniform lifetime table.
For example, continuing with the example above. If you had $5.3 million as of December 31st in the year before you turned 72, you would divide this amount by 27.4 to arrive at your RMD: $194,821.
4. Add other income (social security, pension, dividends, interest, rental income, etc.)
Your RMD is just one component of your income. You must also add anticipated income from social security and other sources to arrive at total income.
5. Determine your expected tax bracket
Below are 2022 tax brackets for a married couple, filing jointly. If a couple had an RMD of $195k, combined taxable social security income of another $50,000, and took the standard deduction of $25,900, then their taxable income would be approximately $219,000. The couple would be in the 24% tax bracket.
6. Compare your estimated tax bracket in retirement to your current tax bracket
Compare your expected tax bracket in retirement to your current tax bracket. If you are in a lower tax bracket today than you expect to be in retirement, then recognizing taxes through a Roth conversion could lower your lifetime tax bill.
What if my tax rates are similar?
If you find your current and expected future tax rates are similar, then you can consider other factors to influence your decision:
- Do you expect tax rates to increase in the future?
- Do you enjoy the certainty provided by paying taxes now?
- Is leaving a tax-free inheritance important to you?
- Do you want to go through the process of making a Roth conversion?
Common Scenarios for Roth Conversions
Roth conversions are not necessarily suitable every year but should be considered if you find yourself in a couple of common scenarios:
1. Low-income years
Roth conversions are generally not advisable for mid-career years with significant income and commensurately high tax brackets. However, there are a few common scenarios during your mid-career years that could open the possibility of Roth Conversions:
- Changing careers
- Stepping away from your job while you have young children
- Starting a business
- Other big life changes that drastically reduce income
These periods may offer an opportunity to convert your tax-deferred assets to tax-free assets.
2. Early Retirement
If you retire before taking social security and/or reaching RMD age, you may have several “gap years” of very low to no-income where you can take advantage of low tax brackets to convert your tax-deferred assets to tax-free assets.
For example, if you and your spouse retire at 60, you may elect to defer social security until age 70 and are not required to take RMDs until age 72. You can use these 10 to 12 years to make annual Roth Conversions at low tax brackets and reduce the size of future RMDs. Although you will pay more in taxes during the gap years, you can significantly reduce your lifetime tax burden and avoid RMDs spiking your tax rate later in retirement.
When might a Roth Conversion not be appropriate?
1. Charitable Giving
If you are charitably inclined, Roth conversions may not be appropriate. Because charities can receive assets directly from your IRA or tax-deferred accounts (so long as you meet certain criteria) and not pay taxes, you would not want to recognize any taxes on these assets through a Roth conversion. Two strategies for using tax-deferred assets for charitable giving include Qualified Charitable Distributions (QCDs) and leaving tax-deferred assets to charity.
QCDs allow individuals to donate up to $100,000 of their RMDs every year to qualified charitable organizations. If you do not require your RMD income for your living expenses, you can choose to donate your RMD to charity and avoid income taxes on this amount. The charity also recognizes the full value of this gift as the charity will not owe taxes on this donation.
Naming a charitable organization as a beneficiary of your tax-deferred accounts also avoids taxes.
In both of these cases, you would not want to recognize any taxes on assets that are earmarked for charity at an effective 0% tax rate.
2. Need the converted amount in less than five years
If you are under 59 ½, Roth conversions are subject to a "5-year rule" which requires converted amounts to be held for five years in your Roth IRA before they are distributed. If you withdraw money prior to fulfilling this 5-year waiting period, a 10% penalty applies to the distributed amount. Each conversion has its own 5-year waiting period.
This five-year rule is intended to close the tax loophole of performing a Roth conversion before age 59 ½ and then immediately withdrawing funds penalty-free. After age 59 ½, this is not a concern.
3. Don’t have funds to pay taxes outside of tax-deferred accounts
Roth conversions have the greatest impact when you can pay the incurred taxes from sources other than your converted funds, especially if you are under 59 ½. Generally, you want to have funds to cover the tax impact outside of the IRA because (1) more money will grow tax-free in your Roth IRA, and (2) you will avoid the 10% early withdrawal penalty.
For example, if you convert $50,000 from your IRA to a Roth IRA and are in the 22% tax bracket, you will incur $11,000 in taxes. If you must fund the tax bill from the converted amount, the $11,000 is no longer part of the conversion and will be subject to a 10% early withdrawal penalty ($1,100). Your $50,000 conversion ultimately leaves only $37,900 in your Roth IRA after taxes and penalties.
4. Retiring in a state with lower income tax
If you currently reside in a state that levies income tax but are considering moving to a state with lower or no income tax, Roth conversions are less attractive. When you convert IRA assets, you are subject to both federal and state income taxes. If you plan on moving from a high-income tax state to a no-income tax state (Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, or Wyoming), then consider deferring taxes (keeping assets in your Traditional IRA) until you reach that no income tax residence.
Roth conversions are a powerful planning tool that allows individuals to better control their tax picture, but they are not a one-time event. It's important to regularly evaluate your tax situation and other circumstances to determine whether you stand to benefit from this valuable planning tool.