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ONE OF MY GOALS for 2020: develop a plan for doing Roth IRA conversions over the next 10 years. Once the money is out of traditional IRAs and in a Roth, it’ll grow tax-free. Problem is, the conversion means taking a tax hit today.
So why am I interested? There are several reasons: lowering lifetime taxes for my wife and me, creating the flexibility to manage future tax bills and leaving a tax-free inheritance to our children. On top of that, today’s depressed stock prices offer a great opportunity to convert shares at a lower tax cost.
My wife and I are both age 62. Last year’s SECURE Act raised the starting age for required minimum distributions (RMDs) from retirement accounts from 70½ to 72. That gives us 10 years to make Roth conversions before we’ll have the enforced—and potentially large—annual tax bills triggered by RMDs.
The decision to convert isn’t a simple one. At its core, it’s a choice between paying taxes today and paying them later. But there are also other significant issues that come into play. Here are seven factors to consider:
1. Whither taxes? As you decide whether to convert, this is the key issue. Would you pay taxes at a lower rate today, if you opt to convert money to a Roth, or would your tax rate be lower later on, assuming you left your traditional IRA untouched and instead simply took distributions some years down the road?
We can’t, alas, predict the future, but we can look to current tax laws. When the Tax Cuts and Jobs Act was enacted in 2017, it reduced marginal tax rates and widened tax brackets. These changes will sunset after 2025 unless Congress passes new legislation.
Reverting to pre-2018 marginal tax rates in 2026 would most likely move my wife and me from the 24% marginal tax bracket to 28%. In fact, many commentators believe that our ballooning government spending will lead to even higher tax rates. I have no idea what will happen, but I strongly suspect future tax rates won’t be any lower than they are today.
2. Paying Uncle Sam. If you convert, you’ll owe income taxes on the sum involved. Conventional wisdom says you should try to avoid paying that tax bill by dipping into your retirement account, because that’ll mean even more taxable income on top of the taxable income generated by the Roth conversion. Instead, you should—ideally—have other money set aside to cover the conversion tax.
3. Today’s bear market. It may seem counterintuitive, but falling share prices offer the opportunity to do a Roth conversion at a lower tax bill. How so? It helps to think in shares instead of dollars. Say you own 1,000 shares of a stock or fund in a traditional IRA. The shares had recently been at $10 but are now at just $5. If you convert the shares to a Roth, you would still have 1,000 shares, but you’d owe taxes on $5,000 of additional income, rather than $10,000.
An added incentive: Roth IRAs have the potential to enjoy a longer stretch of investment growth. Unlike traditional IRAs, Roth IRAs aren’t subject to RMDs once you reach age 72. Instead, the entire account can be left to grow tax-free.
4. Helping your heirs. Roth IRAs are inherited tax-free by the beneficiaries you name. Your spouse can treat the inherited Roth as his or her own, which means there are no RMDs. Meanwhile, non-spouse beneficiaries typically have to empty the account within 10 years. You might advise your heirs to wait until the 10th year to pull money from your Roth, so they get maximum benefit from the tax-free growth.
5. No re-dos. Prior to 2018, you had the ability to undo a Roth IRA conversion up until Oct. 15 of the year after the conversion was made. This “recharacterization” option was eliminated by 2017’s tax law. The upshot: When you convert, you need to be 100% certain you want to do it—because there’s no going back.
6. No early exits. Roth IRAs are subject to the so-called five-year rule, which means you could face income taxes and possibly tax penalties if you tap your new Roth before the five years are up. In other words, if you aren’t sure you can leave your Roth untouched for five years, a conversion isn’t a good idea—and that’s doubly true if you’re under age 59½.
7. Getting it done. There are three ways to execute a Roth conversion:
Our traditional and Roth IRAs are at Vanguard Group, so I used its online system to do a same-trustee transfer. It was very easy: Within a day, the shares had been transferred from my traditional IRA to my Roth.
I’m a semi-retired engineering consultant, so my income fluctuates a lot from year to year. My plan: Look at our total income each quarter to assess our projected tax bill and see if we want to do a small conversion. That way, I can move at least some money into a Roth earlier in the year—and potentially enjoy more tax-free growth—while avoiding an overly large conversion that pushes us into a much higher tax bracket.
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. Rick enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. His previous articles include Buyer Take Care, Numbers Game and Should You Sell. Follow Rick on Twitter @RConnor609.
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I just converted funds from my Vanguard Rollover IRA into my existing Vanguard Roth IRA and it was indeed simple and quick. To pay taxes on it to the IRS, is there a form to download and send along with the check to them? I was thinking of waiting until after July 15 to avoid any confusion with tax year 2019, but want to make sure I am not penalized for being late. Thanks for your insights.
I’ve been following this strategy since I was 59 1/2. I’ll be required to take RMDs for the first time next year, postponed from this year by both SECURE and CARES. Some things that I’d like to add:
Be sure to check your state tax rates too. New York exempts the first $20,000 of retirement income from state taxes so NY residents should consider topping up that too. If you plan to move to another state check the rate there too.
Be very careful if you are receiving Social Security. The formula is rather complex but one dollar of extra income could cause anywhere from zero to $0.85 of SS to be taxed. The 22% tax bracket could become a 40.7% marginal tax rate.
I don’t have any heirs and a sizeable portion of my estate will probably go to charities. Since they will be exempt from taxes on it, at some point it will make sense to leave the money in my traditional IRA rather than pay taxes to convert it to my Roth.
Richard, I am pleased to see that you do not consider a Roth conversion to be a no brainer. There are many instances where a Roth conversion does not make sense. The math has to be done for every individual’s particular situation. Using conservative numbers, 5% return, 22% tax rate and a $1 million amount it would take at least 27 years before the conversion becomes more attractive. The upfront tax liability needs time to be recouped.
On the question of timing a conversion, and whether it’s a good idea to convert in a bear market, you say “It helps to think in shares instead of dollars.” Why? it’s irrelevant whether the $5000 you convert into a Roth represents 1000, 500 shares, or anything other number of shares. $5000 is $5000. Compare: you withdraw $5000 from your traditional IRA, pay $24% in tax, invest $3800 in a Roth at, say, 8% annually. In 10 years you have $8204 tax free. Alternatively, leave the $5000 in the traditional IRA for 10 years at 8%, and you end up with $10,795. Pay 24% tax on that and you end up with $8204 after tax, the exact same amount as if you’d converted to a Roth. It’s only advantageous to convert to a Roth if you think the tax rate will be higher in the future. So it’s a tax issue, not a “number of shares” issue. What am I missing?
I want to thank everyone for the great questions, advice, and contributions. Clearly Roth conversions are complex actions, and I am no expert. I wanted to add a little more about my reasoning for considering them. Many of the replies below hit some of these topics. I am not an expert, and fully admit this is not an easy decision. For several reasons, I like the idea of diversifying the taxability of my future retirement income. The first reason is if income tax rates go up. Tax rates are scheduled to return to pre-TJCA levels in 2026 (who knows what will actually happen then). Also, IRA withdrawals are taxable income, and this can impact SS taxability and Medicare Part B premiums. Also, as others have replied below, there is a penalty for widows. I am married and pretty sure my wife will outlive me. Large RMDs could push her into higher tax brackets.
Richard excellent points. Another factor for married couples is that when the spouse dies they will usually be in a higher tax bracket if they withdraw RMD’s as a single person. Married couples have another reason to convert to Roth accounts than singles.
“Roth IRAs are subject to the so-called five-year rule, which means you could face income taxes and possibly tax penalties if you tap your new Roth before the five years are up. In other words, if you aren’t sure you can leave your Roth untouched for five years, a conversion isn’t a good idea—and that’s doubly true if you’re under age 59½.”
Maybe worth mentioning that this applies only to the profits in the Roth IRA and not on the amount converted–to which no taxes apply. So it is not clear what is the downside of the conversion in this scenario–after all the profits would also be taxable if withdrawn from a traditional IRA, if not converted.
Richard- Excellent points. I do have one fear of converting to a Roth. What could stop Congress from deciding to change the laws and eventually tax my Roth account (again) in ten years?
I have a friend that has been preaching the logic of Roths to me for years. I just bought a book at Amazon,”The Power of Zero” by David McKnight which finally convinced me to try and move (almost but not quite) 100% of my tax deferred bal’s to Roth’s by 12/31/2025, when the TCJA expires. This will mean triggering ~ $1 Million in additional ordinary taxable income over the next 6 tax years, without jumping brackets…glad I didn’t wait another year to get started started. I can convert up to ~ $100K this year without jumping into the 28% bracket, but am going to have to do more than that annually to get it all done in time.
Looking at the many $$ TRILLIONS of deficits being added to the national debt in just the last 60 days , w/ $T’s more on the way, I’m not so sure I wouldn’t even be better off paying taxes on the last $50K or so at a higher 28% marginal rate today (the “devil you know…”) vs gambling on whatever my marginal tax rate will be someday under a President Biden or Warren or Sanders or Orcasio-Cortez!!!
McKnight argues Congress is unlikely to ever directly renege on its promise to tax “either the Harvest or the Seed – but not BOTH”…which changing the tax status of Roth’s would represent. But he finds it very plausible they will change the law prospectively in a few years to prevent any additional Roth contributions/ conversions, while grandfathering all existing balances established prior to that time. If so, that’s just another reason to convert sooner vs later!
Richard, I could not agree more, even though I do not like the idea of volunteering to paying taxes. I don’t see lower taxes in the future. At 67 (and 65) our timeline is shorter, my wife and I will not get it all done, we will start the process. Since we are on Medicare we will also monitor our MAGI, converting to much in a year could could push our Medicare monthly cost higher. The past 7 weeks has provided opportunities to do some tax harvesting which will open the door for a bigger 2020 Roth conversion. I’m not an authority and will seek advice along the way.
Nice write-up Richard. This is a subject I have been studying closely for the last few years, and is of interest to me for many of the reasons you shared. At the top of my list: 1)avoiding the widow(er)’s penalty for the spouse who outlives the other–and it can be hefty; and 2) simplicity. The Roth has fewer “gotchas!” and tax-traps than Traditional IRA’s, which is another very attractive feature to me.
A few other comments may be in order. As for point (6):”Roth IRAs are subject to the so-called five-year rule, which means you could face income taxes and possibly tax penalties if you tap your new Roth before the five years are up.” If you did a conversion after 59 1/2, and IF you tap the newly converted funds before 5 years were up, the *earnings* on those funds would indeed be subject to income tax, but not penalty tax (unless, of course, you neglect to pay the tax due on those earnings in a timely manner). IOW, keep good records. Also, Roths are subject to “last in, last out” rules, so if you had other money already in a Roth it would come out of the account first. As long as your total withdrawal has been in the account for the 5-year minimum, you’re home- (and tax-) free. The main takeaway here: get that 5-year clock ticking ASAP!
As for the actual nuts-and-bolts of doing conversions, it’s good to be aware that very few employer-sponsored retirement plans allow in-plan conversions, even if they offer both traditional and Roth accounts. This usually means liquidating a portion of your traditional account, moving it to an IRA (using trustee-to-trustee transfer, of course) and then doing an in-house conversion (my favored method, anyway). Keep in mind, this can involve several potentially clumsy, awkward, and time-consuming steps, depending on your particular employer’s plan, so it really pays (literally!) to plan ahead. But once you’ve got your money in a traditional IRA, it gets easier from there. The in-house method is the easiest of all, it’s usually quick and painless, a simple form, a few day’s wait at most, and “presto!”, you have a Roth. All you have to do now is pay the tax man, and if you do it with money outside of your retirement accounts, it’s like making a large new contribution to your Roth, without worrying about those pesky “earned income” rules. Which is another win, in my book.