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AMONG THE MOST COMMON debates in personal finance is whether Roth conversions are a wise strategy. Especially as the end of the year approaches, it’s worth looking at both sides of this question.
If you aren’t familiar with it, the idea behind a Roth conversion is that individuals can choose, at any time, and at any income level, to move money out of a pre-tax traditional IRA into a Roth IRA. There’s a catch, though: In the year that you complete a conversion, you must pay income tax on the amount that you convert. So, the bet you are making with a conversion is that your tax rate today will be lower than it will be in the future, when you otherwise would have taken those dollars out of your IRA.
For example, if you could pay a tax of just 22% today to convert dollars from your pre-tax IRA to your Roth IRA, you would happily do that if you expected your tax rate down the road to be much higher—say, 32%.
This seems straightforward, but not everyone agrees. For starters, Roth conversions’ detractors point to the uncertainty inherent in the exercise. Predicting future tax rates is an imperfect science, and if rates end up going lower in the future, that could turn the benefit of a conversion upside down. You could end up paying a higher rate today than you would’ve in the future.
Given the state of federal finances, it might seem unlikely to expect tax rates to go down, but no one can say that with certainty. Congress often changes the rules, and as recently as the late-1980s, the highest ordinary income tax rate was nine percentage points lower than it is today (28% vs. 37%).
In addition, it can be difficult to predict our own future income with precision. Consider required minimum distributions (RMDs) from retirement accounts. They’re a key component of most retirees’ income, but because they’re dependent on future investment returns, the best any of us can do is to estimate this figure.
Roth conversions, in other words, involve uncertainty along multiple dimensions. This is a point even supporters acknowledge. That’s why, to help manage this uncertainty, I look at Roth conversion candidates as falling into one of three categories.
The first category: When a taxpayer’s marginal tax rate is currently in one of the two lowest brackets, either 10% or 12%, I see it as an easy decision to complete a conversion. That’s because it’s hard to imagine that their future tax rate would be any lower. At worst, in that case, a Roth conversion in one of these two lowest brackets might just be a wash.
The second category: When a taxpayer’s marginal rate is over 30%, I see that as an easy decision as well, but for the opposite reason. Roth conversions rarely make sense at that level because it’s hard to make the argument that a taxpayer in a very high bracket might end up in a bracket that’s even higher. To be sure, it can happen—and I’ll describe one clear case below—but it’s hard to have confidence in that expectation. For that reason, a conversion at a rate over 30% typically doesn’t make sense.
The third category: If your marginal rate is in one of the middle brackets—either 22% or 24%—that’s when the conversion decision doesn’t have an easy “yes” or “no” answer, and it’s worth examining other factors.
When would a conversion in this middle range make sense? If the composition of your assets is such that you have significant balances in pre-tax accounts and you haven’t yet hit RMD age (either age 73 or 75), that’s when you’d want to sharpen your pencil. If your RMD based on your current pre-tax balances would push your income into a much higher tax bracket, then it would be safe to assume that, with some additional investment growth, your tax bracket will almost certainly be higher down the road. That’s a clear case for a Roth conversion. Similarly, if you have other income sources, such as a pension, that are guaranteed, that too would make the conversion decision easier.
What if the comparison between your current and projected future tax rates isn’t conclusive? Suppose, for example, your taxable ordinary income today is $210,000. For someone married and filing jointly, that would translate to the 22% marginal tax bracket. Even if your income rose sharply in future years with required minimum distributions, up to $300,000, for example, the tax impact would be modest. Income of $300,000 would translate to a marginal bracket of just 24%. So a Roth conversion might not seem like an urgent priority. In that case, there’s another factor that might be a tie-breaker. If one spouse passed away, the surviving spouse would be subject to the tax brackets for single taxpayers. Continuing with this same example, $300,000 of income would result in a substantially higher marginal bracket of 35%. If that were the case, then a conversion today at 22% might make good sense.
The upshot: If you’re doing Roth conversion math, and the results look inconclusive, consider what might tip the scales.
Another potential tie-breaking factor to consider, if the math isn’t conclusive, would be the estate tax. At the federal level, a tax of 40% applies to assets over $15 million, or $30 million for a married couple. For someone with a balance sheet at that level, Roth conversions can make a lot of sense because they have the result of reducing the size of an estate without reducing the after-tax value of the assets. Consider a simple example: If you complete a conversion of $200,000 that results in $40,000 in taxes, that $40,000 is no longer in your estate, and thus no longer subject to estate tax. This is the only case in which I see an argument for conversions at rates over 30%, because any tax below 40% would still be less costly than the future estate tax levy.
Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on X @AdamMGrossman and check out his earlier articles.
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