It seems like everyone and their mother wants to know if Roth conversions make sense for them. I have heard people sing its praises, throw shade at the mere mention of the idea, and perhaps most commonly a general lack of understanding. Even amongst fairly financially savvy folks, however, I find the Roth conversion to be misunderstood. Let’s clear the air.
- All else equal, pre-tax vs. Roth does not make a darn difference. With pre-tax contributions to retirement accounts, you pay the tax when you take money out. With Roth contributions, you pay the tax when you put it in.
Your investment returns don’t change. Your total dollars also do not change. From a mathematical perspective, they are economically equal.
People have argued this with me because they are convinced that isn’t true. But it only takes a simple example to prove this out.
Let’s say you invest $1,000. You are in the 22% tax bracket. Your investments earn 8%, and you invest for 20 years.
If you invest pre-tax, $1,000 over 20 years becomes $4,660.95.
If you take the money out and pay your tax, you are left with $3,635.55.
If you invest in a Roth instead, you pay tax on your $1,000 up front. $780 goes in and is invested. Over 20 years it becomes…$3,635.55!
The two methods of saving money yield the. Exact. Same. Amount.
Lesson: we need another reason to compel us to choose one over the other.
This is a hypothetical example and is for illustrative purposes only. No specific investments were used in this example. Actual results will vary. Past performance does not guarantee future results.
- Withholding taxes from a Roth conversion tends to defeat the purpose of the Roth conversion. Backing up slightly, converting money from pre-tax accounts (Traditional IRA, 401(k), 403(b), etc.) into a Roth account triggers income tax. If we withhold taxes from the conversion, we are not strengthening the Roth conversion’s potential. We want the most possible dollars going into the Roth where they can grow income tax free. This is why we tend to recommend paying your taxes from taxable accounts (bank accounts, joint investment accounts, regular individual accounts, trust accounts).
- You can only contribute to Roth IRAs when you have earned income, but Roth conversions can be done no matter what your income is. Contributions and conversions are different, and that tends to understandably make people’s heads spin. Think of Roth contributions as when you decide to add money from your bank account–the taxes have already been paid on this money. A Roth conversion, on the other hand, is moving pre-tax dollars into the Roth, which triggers income tax.
- Estate planning can be a legitimate reason to do Roth conversions. There are several places where this makes sense: Suppose you live in Washington and your net worth is above the estate tax exemption. You could convert an IRA over time into a Roth to effectively decrease your net worth on paper. By triggering income tax, you would reduce the value of your estate on paper, potentially helping you stay under the exemption amount. You could also deliberately complete Roth conversions if you think your tax rate is lower than your beneficiaries.
As an example, I recommended to a client that they complete Roth conversions and leave their daughter the Roth IRA. This was because their daughter was a highly successful physician in the 37% income tax bracket who also lived in California and was subject to a 12.3% marginal tax bracket. The clients themselves were in the 22% bracket in Washington with no state income tax (at least for now). By completing Roth conversions, they were achieving what we call “tax arbitrage”.
Meanwhile, their son has almost no income. They named him as the sole beneficiary of the traditional IRA portion they did not convert. He had an effective tax rate of 0%. Had they simply left it alone and made their Traditional IRA 50% to each child, they would have missed out on hundreds of thousands of dollars of tax savings!
This is a case study for illustrative purposes only and should not be construed as a recommendation. It may not be representative of your experience
- Charitable contributions can cancel out most–but not all–of the tax impact of a Roth conversion. This is a fun strategy. Some clients decide to give to their favorite charity (or Donor Advised Fund) in a larger lump sum for one year. If the number is high enough combined with their other deductions to merit itemizing on their tax return, they can sometimes create a sizable reduction in taxable income. This can help cancel out the tax impact of a Roth conversion where you otherwise might have pushed into higher tax brackets! This strategy tends to work best when you “lump” a larger charitable donation rather than spreading it out over multiple years. However: beware. Your taxable income might become lower from your charitable gifting, but it will not reduce your adjusted gross income. That means if you are of Medicare age, your Roth conversion can still cause your Medicare premiums to rise! The charitable gift won’t fix that issue. It can still be worth it to eat the higher premium adjustment if the numbers are right, but managing your income figures is important to avoid unnecessarily canceling out a big chunk of the tax savings you achieve from your Roth strategy. This is something to pay attention to even if you decide to complete a Roth conversion and aren’t even considering a charitable contribution.
- Investment timing in coordination with a Roth conversion can be a very attractive strategy. The thought experiment isn’t too hard to follow, either. Imagine your IRA is invested in the stock market, and the stock market enters a period of volatility. Suppose the account drops 20%. Some people would be quite worried (and understandably so!). Others might see it as an opportunity for a Roth conversion! Continuing the thought experiment, if you complete a Roth conversion while the account is down and then markets rebound to their previous levels, you are still ahead! The investments were switched into a tax-free account, which means the rebound was entirely tax free! Again, this strategy works best when you pay the taxes from another place like your bank account or taxable investment accounts.
- Sabbaticals and even layoffs can be Roth conversion opportunities! If you normally a high income earner but decided to take a break and travel the world for a year, your income might be uncharacteristically low for that year. This could be a special opportunity to complete a Roth conversion and pay at lower tax rates than you normally would! Low income years are often opportunities. There can be silver linings to being out of a job!
Just make sure you don’t do it blindly without considering anything else. You may want to keep your income low so that you can qualify for health insurance subsidies–the savings there can be enormous and override the benefit of a Roth conversion. And you want to be sure you have sufficient savings to afford the tax payment while also having less income coming in.
- Business transactions can create opportunities for Roth conversions. If you buy a business, sometimes there are deductions that help offset your income and can cause a Roth conversion to be attractive. As an example, I have had clients who purchased a fairly mature business and were able to amortize the goodwill over many years. This served as a deduction that lowered their personal income, allowing them the space to complete Roth conversions.
- Roth conversions can help reduce your required minimum distributions, preventing spikes into higher income tax brackets down the road. Many clients will deliberately complete Roth conversions and delay their Social Security after they retire. This window is often between ages 65 and 69. During this period, their taxable income is often fairly low because they have retired, haven’t claimed Social Security, and don’t have required distributions from their Traditional IRA. This can be a strategic window to convert at lower tax brackets and help decrease the Traditional IRA balance…which in turn will decrease the required distributions. This is what we often call a “smoothing strategy”, where we try to keep tax brackets fairly level over time to optimize clients’ tax liabilities over their lifetime.
- Roth conversions are the secret to contributing to a Roth, even if your income might otherwise be too high. This is what we call a “backdoor Roth contribution.” Clients whose income is too high can phase out of being allowed to contribute to a Roth normally. However: there is no income limit to conversions. With that in mind, we often have clients with earned income complete a Traditional IRA contribution, then immediately convert it to a Roth IRA. The Traditional IRA contribution won’t be pre-tax in this case because high income earners will have often phased out of that benefit, but that’s okay! The contribution only briefly lands there so we can then complete the Roth conversion. A last note that this doesn’t work if you have pre-tax money in a Traditional IRA already–trying to complete a backdoor Roth contribution with pre-tax Traditional IRA dollars can cause a tax headache.
- Capital gains and Roth conversions don’t play well with each other. They both raise taxable income. If we decide to realize gains, we effectively have less room to complete Roth conversions, and vice versa, before we start paying higher tax rates. We have the similar issue when a client has an inherited IRA–the client must often choose between distributions from the inherited IRA and completing Roth conversions because both will trigger income tax.
As you can tell, this is a complex, nuanced topic that does not deserve to be labeled as a simply good or bad idea. Some people should never complete a Roth conversion. We find many of our clients could benefit, but only if done carefully and after in-depth financial planning and tax analysis.
It is also important to note that tax rates and rules are hardly set in stone. The best strategies and ideas of today could change on a dime if new legislation is passed. This can cause the Roth conversion conversation to shift into the land of guesswork. We try to create strategies that will benefit clients across many different scenarios.
Helping clients with this kind of planning is something we love to do. We are also happy to collaborate with clients’ CPAs to ensure we arrive at the right decision. We find the best Roth conversion strategies are not a once a year activity–-we are evaluating throughout the year and prepared to implement strategies in light of investment performance, changes in your personal life, and changes on the tax law front. It is an ever-evolving landscape that deserves a fresh look each year.
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