Roth Conversion Or Not?

by | Apr 26, 2024 | Financial Planning | 0 comments

Dear Friends,

Recently, we have fielded questions regarding the option to convert Traditional IRAs into Roth IRAs.  There are many factors that go into making the determination as to who would benefit from this strategy.  To better understand this option, we will begin with a bit of history. In 1997, Congress passed the Taxpayer Relief Act, a piece of legislation that reduced several federal taxes, and as it relates to this article, introduced the Roth IRA. The Traditional IRA, which predated this act, has offered a means to save for retirement and potentially save on taxes, in addition to participating in an employer-sponsored retirement plan. Through the Traditional IRA, one can contribute pre-tax or after-tax dollars and the money grows tax-deferred meaning no taxes are owed until the money is distributed from the account. Those withdrawals are taxed as ordinary income when withdrawn after age 59½. With the introduction of the Roth IRA, individuals can contribute after-tax dollars, and the money grows tax-free so no taxes would be due for qualified withdrawals.

After reviewing some of the basic differences between a Traditional and Roth IRA, it may seem that the conversion decision can simply be made based on one’s current and future tax bracket, meaning the rate at which the funds would be taxed if converted to a Roth IRA today as opposed to the expected tax rate that would be applied if the money were not converted and instead distributed from the IRA in the future.  As with anything in finance, there are additional factors to take into consideration. We will explore these considerations by first understanding the tax equivalency principle as it helps set a baseline of understanding for Traditional and Roth IRA investments.

The tax equivalency principle states that if one’s tax rate remains constant, then performing a Roth conversion today versus taking a distribution from a Traditional IRA in the future would provide the same after-tax outcome. Essentially, there is no benefit to a conversion in this case. This principle holds true so long as the tax rate applied does not change. If one’s bracket is expected to change, then paying the taxes whenever the rate will be lower would be advantageous. From this we can then infer that if the tax rate is lower today, then it would make sense to convert Traditional IRA money. If the tax rate is expected to be lower in the future, then it would be better to leave the money in the IRA and withdraw it once in the lower bracket. At first glance, this seems like an easy decision, but it requires an accurate estimation of what the future tax bracket will be, and to accomplish this there must be a thorough and well-vetted financial plan in place. Additionally, there are a couple of very important exceptions to the equivalency principle that must be taken into consideration before making a conversion decision.

Tax Equivalency Exceptions

  • Required Minimum Distributions (RMD)
        • The required minimum distribution is the minimum amount you must take out of your retirement account after a certain age to avoid a tax penalty. Don’t forget that when money is distributed from a Traditional IRA there will be taxes due. When taking distributions into consideration, the equivalency principle no longer holds true. The opportunity to avoid or reduce RMDs from a Traditional IRA is an advantage of the Roth IRA. The benefit of avoiding RMDs is relatively modest unless the individual lives well past RMD age (currently 73) and avoids large RMDs along the way. Today’s life expectancy is 76.4 years.1 The RMD age will increase to 75 in 2033.
  • Paying Taxes with Outside Dollars
        • The more beneficial exception to the tax equivalency principle comes anytime an individual can max out in the Roth IRA or can use outside cash on hand to pay the taxes of the Roth conversion. This essentially takes any money that would have previously been held outside of the Roth, and been tax inefficient, and redirects it to a tax-preferred savings vehicle. Of course, the time value of money applies here, so if this outside money is redirected sooner rather than later, then you give the tax-free growth an opportunity to work in your favor. This is particularly true if the Roth IRA is meant to serve as an estate asset, as the beneficiary can further delay distributing the funds once they inherit the account. When considering this approach, it is important to ensure that you still have adequate cash on hand for spending needs and emergencies/pop-up expenses. Having to replenish your cash on hand from an IRA because you used your liquidity for the conversion would eliminate the benefit of using the outside dollars in the first place.

There are additional factors that must be carefully considered when evaluating a conversion decision and a few of the more common items can be found below.

  • Tax Rate Determination
        • Don’t forget to look beyond the basic tax tables to see how a conversion could affect your taxes
              • Social Security Benefit Taxation
                    • Roughly 40% of people who receive Social Security benefits must pay federal income tax on their benefit.2 The amount of taxes owed on the benefit is based on the individual’s “combined income” which will include any amount converted to a Roth IRA.
              • Medicare Part B and D Premiums
                    • The premiums for Part B and D are based on Adjusted Gross Income (AGI) which incorporates any amount converted to a Roth IRA. So, a conversion can drive up the premiums paid based on the amount converted.
  • Holding Period Post Roth Conversion
        • The IRA owner’s age, health, and future withdrawal needs should be taken into consideration as they affect the potential time horizon for the investments held in the Roth IRA. Because Roth accounts grow tax free, the economic benefits of a conversion should be more substantial for younger taxpayers and in situations where the IRA owner intends to leave the IRA assets to his descendants at death.
              • If the intention is for the Roth IRA to be transferred to descendants upon the owner passing, then the Roth IRA’s potential future value as well as the beneficiaries’ tax situations should also be taken into consideration when considering a conversion. Beneficiaries who receive a distribution from an inherited Traditional IRA will owe taxes on the tax-deferred money the same as the original owner so their specific needs and tax rates must be closely analyzed.
              • The SECURE Act and SECURE 2.0 Act may make Roth conversions more attractive for some people. Most IRAs inherited by beneficiaries will need to be fully distributed within 10 years of the original owner’s death (exceptions apply for spouses and those less than 10 years younger than the IRA owner, among others). That income could push some beneficiaries into higher tax brackets. Therefore, a Roth conversion could be attractive if those beneficiaries’ tax rates are higher than the rate upon conversion. In addition, the starting age for RMDs was moved to age 73 in 2023 and is set to be extended to age 75 in 2033. These changes may allow individuals more time to execute a conversion strategy.

One of the main takeaways from the above information is that every person’s conversion decision is highly individualized. There may be instances where a person’s tax rate holds constant or even decreases slightly over time and a Roth conversion could still be beneficial. It simply requires a more in-depth and complete analysis.

So far, we have highlighted the importance of understanding the immediate tax implications associated with a Roth conversion and now we will explore some ways to minimize those taxes. This is particularly important for larger conversions as a large conversion in a single year has the potential to push a taxpayer into a higher tax bracket and to a point where it negatively affects the individual’s wealth. To avoid this outcome, a partial conversion is frequently the optimal strategy to take advantage of lower tax brackets without crossing into the top tier brackets.

Partial Roth Conversion Considerations

  • When to accelerate income and when to defer income
        • In general, accelerate income (perform Roth conversions) when in lower tax brackets
            • 10%, 12%, 22%, 24%
        • Defer income in higher brackets
            • 32%, 35%, 37%
        • Maximize Lower Tax Brackets
            • If it is determined that a conversion would be optimal for one’s financial plan, then plan to convert an amount that utilizes the entire available bracket(s) without crossing over into undesired brackets.
        • Identify Low Tax Rate Opportunities
            • When looking at your financial plan, try to identify low tax rate opportunities and take advantage of them. For those who are approaching retirement, there is frequently a low tax opportunity during the period of time after retirement and before needing to take required minimum distributions.

The intention of this article is to provide readers with insights into some of the more common considerations when looking at Roth conversions and to inspire discussion as to when this strategic and complex tool may be appropriate for each individual. If The Legacy Foundation can ever be of assistance with Roth conversion questions or any of your financial planning needs, please do not hesitate to reach out.

Sources:

  1. Life Expectancy. Center for Disease Control. https://www.cdc.gov/nchs/fastats/life-expectancy.htm
  2. Income Taxes and Your Social Security Benefit. Social Security Administration. https://www-origin.ssa.gov/benefits/retirement/planner/taxes.html

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

This information is not intended to be a substitute for specific individualized tax advice.  We suggest that you discuss your specific tax issues with a qualified tax advisor.

Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.