Roth Conversions – When It Makes Sense and When It Does Not
By Scott Snider
KEY TAKEAWAYS
A Roth conversion is a transfer of retirement assets from a pre-tax traditional IRA, SEP IRA, SIMPLE IRA, 401(k), or other defined contribution plan into a Roth IRA or Roth 401(k).
What can get overlooked about Roth conversions is the fact that you are merely choosing when you pay your taxes on that investment – now or later.
Retirees with million-dollar IRA balances may want to consider Roth conversions as a wealth building strategy, thereby reducing their taxable income when Required Minimum Distributions (RMDs) start kicking in at 73.
Roth Conversions are an inefficient wealth transfer strategy whenever IRA dollars are intended to go to a charity because charities are tax-exempt organizations.
On the surface, converting your traditional IRA to an investment vehicle that offers tax-free benefits like a Roth IRA sounds like a great idea. Why is that? It boils down to one thing – the words TAX-FREE. Americans love the word FREE, especially when it is associated with taxes. You might be a Russian communist if (in my Jeff Foxworthy voice) … You enjoy giving the government all your money.
However, what sometimes gets overlooked about Roth conversions is that you are merely choosing when you pay your taxes on that investment – now or later. Uncle Sam is going to get his one way or another. Given this tradeoff, it’s prudent for investors to take a step back and proceed carefully.
The main reason to be cautious about Roth conversions is that the ability to reverse it, in the event you are suffering from buyer’s remorse, is no longer an option. This is thanks to a provision within the Tax Cuts and Jobs Act (TCJA), implemented in January 2018, that eliminated Roth recharacterizations. Therefore, when deciding if converting your IRA to a Roth makes sense, it’s important to evaluate several factors – your age, your income now, your income in the future, your tax bracket before the conversion, and your tax bracket after the conversion. From there it gets easier to decide how much to convert, if any.
Under the right set of conditions, a Roth conversion can be a home run. This article aims to help you sort out the situations when a Roth conversion is an effective strategy towards building your wealth, your family’s wealth, and when it’s a trapdoor that ought to be avoided.
ROTH CONVERSION BASICS
Before overviewing Roth conversion strategies and pitfalls, it’s important to understand how a Roth conversion operates. A Roth conversion is a transfer of retirement assets from a pre-tax traditional IRA, SEP IRA, SIMPLE IRA, 401(k), or other defined contribution plan into a Roth IRA or Roth 401(k). The transfer of assets can be completed via a direct rollover, a trustee-to-trustee transfer, or a 60-day rollover. Additionally, you can structure your conversions by converting the entire amount in your traditional IRA in a single year, or by spreading out those conversions over multiple years.
The consequence of the Roth conversion is that the dollar amount of assets that gets converted will be included in your taxable income during that calendar year. Whereas the advantage is that the withdrawals from the Roth IRA are eligible for tax-free withdrawals, assuming 2 conditions are met – you wait 5 years, and you are over the age of 59 ½.
The graphic below helps to better illustrate how a Roth conversion works for a single person who is earning $75,000 and converts $100,000 to a Roth IRA at a tax rate of 24%, paying the taxes due from funds outside the IRA:
WHEN A ROTH CONVERSION CAN ENHANCE YOUR WEALTH
As it turns out, there are 6 situations that investors might benefit from doing a Roth conversion:
1) You Believe Tax Rates Will Be Higher in the Future
Basing your decision on whether to convert your traditional IRA dollars to a Roth IRA is better understood when you realize that you really are trying to decide when you want to pay taxes on your retirement assets – now or later. To keep it simple, your goal is to pay the least amount in taxes. In other words, when converting to a Roth you are footing the tax bill upfront because you expect your marginal tax rate to be lower now compared to when you are retired.
While most retirees expect their income to be lower in retirement, this isn’t always the case. In fact, Required Minimum Distributions (RMDs) have the potential to sneak up on a retiree and push them into a higher bracket than they planned for. Additionally, the lower tax rates enacted by the TCJA are scheduled to sunset at the end of 2025. What this means is that even if your income remains unchanged, when you begin taking distributions in 2026 you are likely to pay higher taxes. As you can see in the tax table below, a married couple earning $160,000 under the TCJA currently has a marginal tax rate of 22%, but when the more favorable rates sunset their marginal rate will increase to 28%.
Mercado, Darla (December 15, 2017). "Find your new tax brackets under the final GOP tax plan". CNBC.
Congress may continue to modify tax rates in the future, but of course those insights won’t be known until future legislation is passed.
2) You Experience a Drop in Income
This scenario can be the golden goose of Roth conversions. Considering that a temporary drop an income offers the IRA owner the ability to convert their retirement dollars at a lower tax rate than the rate he/she generally pays. Some situations where this might be advantageous include retirement, employment change from full-time to part-time, a loss of a job, an extended leave of absence from work without pay, or a large operating loss if you own a business.
3) You are Young
One of the attractive features associated with Roth IRAs is that they provide tax-deferred growth. This is most beneficial if you have time on your side because the compounding effect of tripling or even quadrupling your money means that you only paid taxes on the original investment. In other words, most taxpayers would rather pay taxes on $100,000 and not on $400,000. To achieve this level of compound growth it typically takes decades and is why younger investors benefit even more from Roth IRAs.
4) Your IRA Investment Portfolio is Down
Sometimes a market correction is a blessing in disguise. That might be the case if you are in a position to do a Roth conversion. Think about it this way, you own the same number of shares of stock and are converting those shares at a lower market value. For example, you own 500 shares of XYZ fund in your traditional IRA and intend to continue to hold that fund as a long-term investment – it was worth $70,000, and now it’s worth $40,000. By converting your shares of XYZ fund, you only paid taxes on $40,000 rather than $70,000. In this scenario, you benefit from assuming that XYZ fund will eventually be worth $70,000 again at some point in the future, but you only had to pay taxes on the converted amount.
5) You Want to Reduce Taxes Related to RMDs
As previously mentioned, RMDs have a funny way of sneaking up on retirees who have a large amount of their nest egg in traditional IRAs – on the account of the fact that the taxes can be significantly higher than one anticipated. A 73-year-old IRA owner with a $5M balance is required to withdraw $188,679 from their IRA, according to the IRS’s tables. Assuming that person is single, their tax rate is already in the 32% bracket, and that doesn’t even include other potential sources of income like social security and pensions. Further compounding the issue is that the required percentage being distributed only goes up with each passing year.
6) Your Goal is to Minimize Taxes to Your Heirs
One of the other benefits of a Roth IRA is that they are exempt from the RMDs during your lifetime. Therefore, the investments can continue to grow with compound interest. Additionally, the Roth IRA passes to your beneficiaries, and they receive their mandatory distributions tax-free. This makes the Roth IRA a great wealth transfer vehicle for people who want to leave a legacy to a loved one that is in higher tax bracket than the current IRA owner. Even if your heirs are likely to be in a similar, or even lower tax bracket, inheriting a Roth IRA might be better tax-wise because the IRS only permits most heirs to distribute the inherited IRA over a maximum of 10 years. So, during those 10 years, if they were to inherit a large Traditional IRA with taxes owed on each year’s distribution, their income tax bracket may be much higher.
WHEN A ROTH CONVERSION MIGHT HARM YOUR WEALTH
The obvious tax advantages of a Roth IRA – which are highlighted in greater detail in our other blog article, Why Choose a Roth IRA – have made it such that Roth conversions have grown in popularity. Examples of the hysteria might include, “my BFF converted her entire IRA to a Roth, so it must be right for me… Right?” Or “I read somewhere on Facebook that I should convert everything to a Roth IRA.” Unfortunately, relying on hearsay or reading the latest trendy online article can do more harm than good sometimes.
In fact, there are 5 legitimate reasons that Roth conversions can be harmful towards building wealth, including:
1) You Are in a High Tax Bracket
Is it really better for someone in the highest tax bracket (39%) to do a Roth conversion? While your answer is likely “no - duh.” The allure of tax-free income later in retirement has tricked some investors into thinking this is the way to go. Is it a devastating decision in most cases? Probably not. However, the tradeoff can be significant. Say you decide to convert $200,000 while in the highest tax bracket at 39%, but in retirement your tax rate (with the conversion factored in) will be 25%. You just cost yourself $28,000 in taxes. As Scooby Doo famously coined the phrase back in 1969, “Ruh Roh!”
2) Retirees Expecting to Bounce their Last Check
A Roth conversion is best avoided when an individual is likely to spend all their money in their own lifetime – whether the spend down is intended or not. The reason being is that paying a large sum of taxes upfront leaves this person with less overall financial resources at their disposal for the remaining years they intend to live on their nest egg. It’s much better to spread out the IRA tax liability over their lifetime, thereby giving that individual a better chance to stretch those dollars longer.
3) Large Tax Deductions
Individuals that are in poor health, have a chronic condition, or have a family history of Alzheimer’s/dementia may want to think twice about Roth conversions. At least during the years in which they expect to incur significant medical costs. This is because the IRS allows you to deduct unreimbursed medical expenses that exceed 7.5% of your adjusted gross income (AGI).
Therefore, individuals with higher medical bills, relative to their income, can use those deductions to reduce the income taxes generated from their IRA withdrawals and/or RMDs. As it turns out, nursing home expenses, in certain instances, can be counted as medical expenses.
Where this deduction can be taken to the next level is when an individual is considering buying into a Continuing Care Retirement Community (CCRC). That is because the person can write off a portion of their down payment as a medical deduction. Given the sums typically required upfront, the deduction in this instance can sometimes exceed the hundreds of thousands.
4) Your Primary Beneficiary is a Charity
For traditional IRA owners who intend to give that portion of their estate to a charity – whether it be because they don’t have heirs to give their money to or they have certain funds earmarked for that purpose – converting those dollars to a Roth is an unnecessary cost. That is because qualified non-profit organizations are tax-exempt. Meaning the charity does not have to pay taxes on any distributions from a traditional IRA. Why bother paying the taxes during your lifetime and then have potentially less go to the charity? Go for the win-win instead.
5) Shorter Life Expectancy
Because a Roth conversion requires you to front-load your tax liability from you IRA, the hope is that you live long enough to reap the benefits. In most instances, retirees with life expectancies of 5-10 years considering a Roth conversion are better off keeping their money in their IRA. If we dig a bit deeper into why that is – there is a breakeven point in time when the Roth conversion becomes more economical. In other words, the taxes you paid are an eventual tax-free investment that pays off after X number of years. In most instances, the breakeven point doesn’t occur until about 15 years or later.
IS A ROTH CONVERSION RIGHT FOR YOU?
There are other atypical scenarios that can change the trajectory of the economic benefits, so if you aren’t sure if a Roth conversion is right for you, we suggest consulting with an expert or continuing to scour the internet for more information. However, I want to caution the DIY approach for novices. The numbers generated by the breakeven calculators that you will find online often need more context if you want to truly understand if a Roth conversion will benefit you or not.
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