When Does a Roth Conversion
Make Sense?
Over the last year, we’ve had many discussions with clients about required minimum distributions, how they affect taxes, and how to manage retirement tax liability through Roth conversions. While Roth conversions are a commonly touted solution, we find that paying tax now only makes sense when the long-term benefit outweighs the cost incurred today. As we approach the December 31st Roth conversion deadline, here are a few considerations.
What is a Roth conversion?
A Roth conversion moves money from a pre-tax retirement account into a Roth IRA. The amount converted generally counts as taxable income that year. Afterwards, qualified growth and withdrawals are tax-free, for both you and your heirs. For you, withdrawals generally qualify once you’re 59½ and the Roth has been open at least five years. Roth conversions are completely optional, and no one is ever required to convert. Basically, you can think of it as choosing to pay tax at a known rate today in order to manage your tax liability down the road when that rate is unknown.
When might a conversion make sense?
You plan to leave your IRA to your children. If you own an IRA, don’t plan to take anything more than your RMDs, and have high-earning children, it could make sense to make Roth conversions now. If you leave a traditional IRA instead, the 10-year rule means most heirs must distribute the entire amount as taxable income within 10 years (surviving spouses and certain other beneficiaries have different rules). For high-earning children, this can add significant income they may not need to an already substantial tax bill. Most non-spouse beneficiaries must also empty an inherited Roth IRA within 10 years, but those withdrawals are generally tax-free.
You have a low-income year. A common opportunity to make Roth conversions is for those who have retired early and have many years before they take Social Security. For example, someone retiring at 62 who plans to delay Social Security until age 70 may have several years when they are in a much lower tax bracket than while working, or than after Social Security and required minimum distributions begin. Alternatively, someone with a dip in income for a couple of years could use those years to opportunistically pursue Roth conversions while their marginal tax bracket is lower.
When should you think twice?
You’d have to pay the tax out of the IRA. If you’d have to pay the taxes out of the IRA itself, you should really take a close look at whether a Roth conversion makes sense. If you’re also under age 59½, the amount withheld counts as an early withdrawal and generally carries a 10% penalty.
You expect to be in a lower bracket in retirement. If you’re currently in, say, the 32% bracket and expect to be in the 22% bracket in retirement, converting may not make sense on tax-rate grounds alone, unless other goals, such as leaving tax-free money to your heirs, change the picture.
Unintended consequences. A conversion raises your income for the year, meaning more of your Social Security could become taxable, your Medicare premiums (IRMAA) might rise, and you could end up losing credits or deductions.
You plan to leave IRA money to charity. If you intend to leave that money to charity, converting it would likely mean paying tax that would otherwise never be owed, since charities don’t pay tax on inherited traditional IRAs.
Important considerations
- Partial conversions often make more sense. Converting a large IRA balance all in one year will likely put you in a significantly higher tax bracket. Smaller conversions spread over several years can help manage tax costs. (Ex: if your taxable income is $12,000 below the top of the 24% bracket, converting about $12,000 would use that room without pushing you into the 32% bracket)
- You can pay the tax from outside savings. When possible, it’s usually better to pay that tax bill from a checking, savings, or brokerage account, as long as using those funds doesn’t strain your cash reserves. Paying from outside savings allows the full amount you’re converting to grow tax-free in a Roth account. If you withhold part of the conversion to pay the tax, less money will end up in the Roth, shrinking the benefit.
- Non-spouse heirs can’t convert an inherited IRA. Non-spousal heirs (such as children) can’t convert an inherited traditional IRA to a Roth.
- Coordinate with your tax professional. If you have a CPA or other tax professional, we recommend talking with them about the impact of a Roth conversion, since the effects on Social Security taxation and Medicare premiums require evaluating your broader tax situation.
How we evaluate a Roth conversion
When evaluating a Roth conversion, our goal is to compare your likely bracket today with your likely bracket in retirement.
First, we review last year’s tax return as a starting point, then update it with this year’s expected income and deductions to see how much room is left in your current bracket. To estimate your bracket in retirement, we look at your IRAs and 401(k)s and create a projection of what your tax bill might look like when withdrawals begin, including required minimum distributions. We also want to make sure there’s another account from which you can pay the tax you owe on the conversion. Finally, we want to discuss your beneficiary designations, particularly if saving on taxes for your children is a motivation or if you plan to donate a portion of your estate to charity.
Once we have reasonable assumptions in place to produce your projections, we compare different conversion amounts over several years to identify an appropriate amount, if any.
Let's run the numbers
Roth conversions get complex fast, so it’s worth running the numbers before acting. We use tax-planning software to model whether a Roth conversion is a good choice for your situation before making a recommendation. Since conversions must be completed by December 31, now is a good time to review. If you’d like to see whether a conversion, or a series of partial conversions, could fit your retirement tax plan, please click the link below to set up a call.