To Roth or Not?

Rick Moberg

SHOULD YOU CONVERT your traditional IRA to a Roth IRA? Below, you’ll find five questions to help you decide. If you answer “yes” to the first three questions, you’re a good candidate for a Roth conversion. If you answer “yes” to all five questions, you’re an outstanding candidate.

Question No. 1: Are you taxed at lower rates today than you will be in future?

Roth conversions make sense if your federal and state tax rates today are below what they’ll likely be when you have to take required minimum distributions (RMDs) from your traditional IRA. Conversions present a tax arbitrage opportunity—paying income taxes today to avoid paying higher taxes later. Here are three common scenarios where converting can be attractive.

First, you’re in the conversion “sweet spot.” This sweet spot begins when you retire and ends when you must take RMDs from your traditional IRA. Tax rates can be lower during this stretch because you have no income from employment, Social Security and traditional IRA RMDs. Once you turn age 72, income from Social Security, traditional IRA RMDs, investments and pensions may push you into higher tax brackets.

Second, you plan to leave a large traditional IRA to your heirs. Your non-spousal heirs will have 10 years to empty an inherited traditional IRA. They may have to pay significant income taxes on your traditional IRA, especially if they’re in their peak earnings years when they draw down the account—and thus the taxable IRA withdrawals are on top of their own taxable income.

Third, converting can be attractive if it’s a favorable tax environment—like we’re enjoying right now. The Tax Cuts and Jobs Act of 2017 reduced the number of federal tax brackets and lowered individual tax rates. The law is scheduled to sunset at year-end 2025. While it’s impossible to predict what will happen to tax rates then, folks with large traditional IRAs should consider converting now in case today’s low tax rates disappear.

Question No. 2: Can you hold Roth assets for a long time?

Conversions are more attractive if you can leave converted assets in a Roth for as long as legally possible. More time means more tax-free earnings growth. Folks who intend to leave Roth assets to their heirs make the best conversion candidates, because tax-free earnings growth can occur over their remaining lifetimes, plus up to 10 years after their deaths.

Meanwhile, people who must withdraw Roth assets to fund their retirement are in a tougher spot, because their tax-free earnings growth may be limited. For these folks, conversions may not make sense.

Question No. 3: Can you pay conversion taxes from a taxable account?

Conversions are more attractive if you can pay taxes from a taxable account, rather than covering the tax bill with funds from your traditional IRA. Why? There are two reasons. It’s a little complicated but bear with me while I explain.

First, if you pay the conversion taxes with a withdrawal from your traditional IRA, you must pull enough money from the traditional IRA not only to make the conversion, but also to pay taxes, which includes taxes on the amount you withdrew to pay taxes. Got that?

Let’s say you converted $100,000 to a Roth and your tax rate was 25%, so the tax on the $100,000 conversion would be $25,000. But if you’re paying the conversion tax from your traditional IRA, you would need to withdraw $133,333—not $125,000, as you might assume. The reason: The extra $8,333 is needed to pay taxes on the $25,000 tax withdrawal. By contrast, if you paid taxes from a taxable account, you could convert $100,000 from your traditional IRA and pay $25,000 from your taxable account, effectively saving yourself $8,333 in taxes.

That brings us to the second benefit of using your taxable account to cover the tax bill: If you do that, you effectively move the money involved from your taxable account into your Roth, where it grows tax-free thereafter. To understand why, consider two scenarios.

In scenario No. 1, you distribute $100,000 from your traditional IRA and make a $75,000 conversion, using the remaining $25,000 to pay the conversion taxes. In scenario No. 2, you distribute $100,000 from your traditional IRA and make a $100,000 conversion, paying the $25,000 tax bill from your taxable account. In each case your traditional IRA declines by $100,000 and you pay the government $25,000. But in scenario No. 2, you wound up with an extra $25,000 in your Roth, because you paid the taxes from your taxable account. In effect, it’s like you made a $25,000 contribution to your Roth.

Question No. 4: Are you married?

Roth conversions can be attractive for married couples because the death of one spouse can have severe adverse tax consequences. Why? The surviving spouse must file taxes as a single individual. The survivor will almost certainly be pushed into higher tax brackets, which means traditional IRA distributions will be taxed at higher rates.

The problem is further exacerbated if both spouses have traditional IRAs, because the surviving spouse must take RMDs from his or her own traditional IRA, as well as from the deceased spouse’s IRA.

Question No. 5: Will your estate owe estate taxes?

Roth conversions may lower estate taxes if your estate will be subject to estate taxes. Estate taxes are levied on the value of an estate. Roth conversions reduce the value of an estate by “pre-paying” income taxes on traditional IRAs. In other words, the value of an estate will be lower if it includes after-tax Roth IRAs versus before-tax traditional IRAs.

Suppose Sandy, a Massachusetts resident, has an estate that’s subject to state, but not federal, estate taxes. If Sandy converted $2 million to a Roth during her lifetime and paid $600,000 of conversion income taxes, her estate would not be taxed on the $600,000. Since the top estate tax rate in Massachusetts is 16%, her estate would avoid that 16% tax on $600,000, equal to a state estate-tax savings of $96,000.

Rick Moberg is the retired chief financial officer of a publicly traded software company. He has an MBA in finance, is a CPA and has a passion for personal finance. Rick lives outside of Boston with his wife.

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Rick Connor
Rick Connor
2 years ago

Rick, excellent article on a tough subject. I really like the clear, concise way you break down the key issues and explain the tougher concepts. Well done.

2 years ago

You forgot about people like myself that are paying Obamacare premiums…they cant do conversions at all because it would put them over “the cliff” and then they would be inelegible. The ignorant people who forged obamacare didnt bother to worry about that.

2 years ago

There’s a good reason they call Massachusetts -“TAXachusetts”.

Rk Mohan
Rk Mohan
2 years ago

Regarding Question 3, last para: “…. paying the $25,000 tax bill from your taxable account”. What cannot be ignored is that the $25K has an opportunity cost. The Roth conversion amount must have sufficient time to make up the principal and investment income lost on the $25K – as indicated in Question 2, first para. Longer the time frame, better the conversion looks. Current and recent retirees have to be really careful.

11 months ago
Reply to  Rk Mohan

I question the wisdom of paying taxes on the conversion using aleady taxed money. If the taxable account money was taxed @ 22%, would not you be paying an extra $7,050 versus using the $25K from your IRA?
Correct me if I’m wrong, but I’m thinking that the Taxable account money is equivalent to $0.78 for each $1. (math -> $25000 * (1/.078) = $32,051.28

Jonathan Clements
Jonathan Clements
11 months ago
Reply to  oldfartiv

If you have money sitting in a savings account in a regular taxable account, that money would be taxed at 0% if you withdrew it and then used it to pay the tax bill on a Roth conversion. If we’re talking about a stock in a taxable account that you bought for $60 and sell for $100, the tax might be 15% of the $40 in appreciation, equal to 6% of the $100 total, leaving you with $94 to pay the Roth conversion tax bill.

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