When to Roth

Adam M. Grossman

MY 10-YEAR-OLD SON and I had a chance encounter last month with the commissioner of the Boston Police Department. After saying hello, he bent down and offered my son this advice: “Stay in school,” he said, “and listen to your parents.”

Often, the recipe for childhood success is just that simple. Ditto when it comes to managing money. The basic principles are usually pretty straightforward. But there’s one topic that often leaves people with a headache. That’s the question of whether, or when, to do a Roth conversion. At the risk of giving you a headache, that’s the issue I’m tackling today.

If you’re not familiar with it, here’s the idea behind a Roth conversion: Individuals can choose, at any time and at any income level, to move money out of a traditional IRA and into a Roth IRA, where the money will grow tax-free thereafter. There’s a catch, however. In the year that you do a conversion, you must pay income tax on the taxable amount you convert. The bet you’re making is that your tax rate today will be lower than it will be later on, when you otherwise would start taking money out of your IRA.

That involves several unknowns. Not only do you have to estimate your future income, but you also need to guess whether Congress might change the tax code again. And if you think your children might ultimately inherit your IRA, you’ll need to factor in their tax situation. Worse yet, as of this year, Congress took away taxpayers’ ability to “recharacterize”—or undo—a conversion, so you really want to be confident you’re making the right choice before you go ahead.

Absent a crystal ball, there’s no foolproof way to make the decision. But these are the steps I would recommend:

Step 1: Determine your current marginal tax rate. The term “marginal” refers to the tax rate on the last dollar that you earn. Typically, this isn’t difficult. But because new rules went into effect in January of this year, you might ask your accountant for help, if you have one.

Step 2: Try to estimate, however roughly, what your income will look like in retirement. Conventional wisdom says that your income, and therefore your tax rate, will always be lower in retirement than while you’re working. But you’ll want to test this assumption rigorously. The following formula is a starting point for estimating your taxable income in retirement:

Now, compare your current tax rate to the rate that would apply in retirement. If you’re confident that your future tax rate will be demonstrably higher than it is today, consider doing a conversion now. Otherwise, I would wait.

Step 3: If you’re currently in the highest bracket, or if a Roth conversion would put you in the highest bracket, then you probably won’t want to do a conversion. There are, however, two exceptions to consider.

Exception No. 1: If you believe Congress will raise rates in the future, it’s possible that your tax rate could be even higher down the road. It may seem hard to imagine, but as recently as 1981 the top tax bracket was 70%. I wouldn’t base a decision on this kind of speculation. But some people feel strongly that our fiscal situation will require higher tax rates, so it’s something to consider.

Exception No. 2: If your assets are likely to make you subject to the federal estate tax—meaning you have more than $11 million and you’re single or over $22 million and you’re married—it might make sense to do a Roth conversion during your lifetime, even if you’re in the highest tax bracket. That’s because the income taxes you would pay to do the conversion would reduce the size of your estate, and hence your estate’s tax bill, thus increasing your estate’s after-tax value for your children.

Step 4: Be sure you can afford it. Unless you are older than age 59½ when you do a Roth conversion, you’ll need additional funds to pay the associated tax—because you can’t dip into your IRA to pay the taxman without triggering tax penalties.

Step 5: If the calculations you do in steps 2 and 3 don’t favor a Roth conversion today, that doesn’t mean it will never make sense. For planning purposes, it’s worth forecasting when the math might work out. For most people, there’s a brief window, just after you stop working but before age 70, when your income may be low enough to accommodate a conversion.

To evaluate this, I suggest using the above formula to estimate your tax rate during those early retirement years. If you foresee a period of low-tax years, you may want to mark your calendar and plan for a series of conversions during those years. Keep in mind that, if you do a Roth conversion in your 60s, you may not only increase the income taxes on your Social Security benefit, but it could also boost the Medicare premiums you pay.

As you can see, the Roth conversion question isn’t easy. For that reason, my overall recommendation is this: After working through these steps, I wouldn’t do a conversion unless the numbers clearly and conclusively favor it. If the math is at all inconclusive, I would wait and revisit the question each year in the future.

Adam M. Grossman’s previous articles include Not for YouOff Target and Just Like Warren. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.

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4 months ago

A third exception to Step 3 is for a couple is theirs expected survivor tax rate. Whether it is due to the gender lifespan delta or age delta or health delta of the couple, once the survivor begins filing as a single their tax brackets are cut in half. So unless the survivor’s income is cut in half (not recommended to live), the increased survivor’s tax rate will likely increase.

Kenneth Tobin
Kenneth Tobin
4 months ago

Lange suggests converting to the top of the 24% bracket. At the end of 2025 these tax cuts end. I have done Roth co.nversions to have a so.urce of income instead of buying a LTC policy. If the IRA will be inherited, a conversion might make sense as the person who inherits the T-IRA might very possibly be in a much higher tax bracket. Paying the tax now might make sense

4 years ago

When I was a young man entering the work force after college the tax deductible IRA was born. Back then the accounts were hailed for having two benefits. One, get a tax deduction right now for the contribution and let your money work tax deferred until retirement. Secondly, when it came time to pay taxes on your IRA withdrawals in retirement, you’d be paying Uncle Sam with money that was worth less due to inflation. The idea was to keep your “good” dollars working for you in the present and pay the tax man later with money whose purchasing power had eroded over the years. Made sense.

Now, that equation has been reversed. When converting to a ROTH we are giving Uncle Sam our good dollars now in exchange for having a tax free account later. I’m not saying that all ROTH conversions are a bad idea. What is the break even point on a conversion? There is an opportunity cost associated with paying taxes in the present.

Jonathan Clements
Jonathan Clements
4 years ago
Reply to  Bob

As Adam explains in his blog post, it all comes down to tax rates. If your tax rate is the same or higher in retirement, the Roth is usually the best bet. If it’s lower, the tax-deductible account is the better bet. You can think of the taxman as a part owner of your retirement account. You can either pay him now (fund a Roth with after-tax dollars) or later (get a tax deduction now, but pay taxes later). Suppose you earn $5,000 and pay tax at 20%. You can either put the full $5,000 in a tax-deductible IRA or, after today’s taxes have taken their bite, stash $4,000 in a Roth. Imagine the account has doubled in value 10 years later. The Roth would leave you with $8,000 — all tax-free. The tax-deductible IRA leaves you with $10,000 — before taxes. If you’re still paying tax at 20%, the tax-deductible account leaves you with $8,000, after taxes — same as the Roth.

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