By Dr. James M. Dahle, WCI Founder
As I've written before—both about Roth Conversions and Roth 401(k) Contributions—decisions about whether to do a Roth conversion and whether to make Roth or traditional 401(k) contributions are complex and depend, in part, on information that is unknown and even unknowable. These are complex and difficult decisions. People want a simple little calculator to help them decide, but as Einstein said, we should “make things as simple as possible, but no simpler.” There are guidelines and rules of thumb, but they have plenty of exceptions.
Today, we'll discuss 10 principles to keep in mind as you make these decisions on Roth conversions and contributions.
#1 Use Tax Rates, Not Tax Paid
The first principle addresses a common misconception—that it is better to “pay taxes on the seed than on the harvest.” The truth is that it doesn't matter whether you pay taxes on the seed or on the harvest if the tax rate is the same. Let's say you have 10 seeds and a 20% tax rate. You can pay two seeds in tax now or you can plant all 10 seeds, grow 10 trees, collect two big baskets of fruit from each tree, and then pay four baskets of fruit in tax. You end up with the same amount of fruit either way.
Paying tax on seed (i.e., Roth or tax-free)
10 seeds minus 2 seeds in tax = 8 seeds = 8 trees = 16 baskets of fruit
Paying tax on fruit (i.e., traditional or tax-deferred)
10 seeds = 10 trees = 20 baskets of fruit minus 4 baskets in tax = 16 baskets of fruit
Same, same.
#2 Fill the Tax Brackets
The second critical concept to understand is that you fill the tax brackets as you go. For example, when you do a Roth conversion or Roth contribution, you are generally doing that “at the margin,” often at a rate of 32%, 35%, or even 37% as a high-income professional. That means if you convert $10,000 (or choose Roth over traditional for $10,000), the tax cost of that decision is $10,000 x 37% = $3,700. If you avoid the Roth conversion (or make a traditional contribution), you save $3,700 in taxes.
However, later in retirement, you may not be withdrawing all of that tax-deferred money at 37%. In fact, if you have little or no other taxable income, you can withdraw a lot or even all of the money at dramatically lower tax percentages. Consider a 60-year-old married couple with no taxable income other than withdrawals from a tax-deferred account. Using rounded numbers, this couple can do the following:
- Withdraw $26,000 at 0% (standard deduction)
- Withdraw $20,000 at 10% (10% bracket)
- Withdraw $63,000 at 12% (12% bracket)
- Withdraw $95,000 at 22% (22% bracket)
The total tax cost of that $204,000 withdrawal = $30,460, or a rate of just 15%. I assure you that contributing at 37% and withdrawing at 15% is very much a winning strategy. Consider the following chart to demonstrate the concept.
But what if all those other brackets are filled up with other sources of income? For example, consider someone who made tax-deferred contributions at 22% and then in retirement found that they found they had the following other sources of taxable income:
- Taxable portion of Social Security: $60,000
- Pension: $25,000
- Investment property rental income: $80,000
- Ordinary dividends and interest: $50,000
Total income, not including tax-deferred account withdrawals: $215,000
This person has filled up the 0%, 10%, 12%, and 22% brackets with other income. If they also want to take $200,000 a year out of that tax-deferred account, it will be mostly taxed at 24% with some taxed at 32%. That's not a winning strategy at all.
Note that changes in your own personal income level matter dramatically more than changes in the tax rates themselves. It really doesn't matter if the top income tax bracket rates go up by 2% or 3% if all of your withdrawals will be in the lower brackets. But a slight decrease in tax rates does matter if you saved so much money that you'll be in a higher bracket in retirement than you were during your working years.
Remember also that long-term capital gains and qualified dividends are always added to taxable income last. So, in the unusual situation where an investor has a relatively small amount of ordinary income and a relatively large amount of qualified dividends and long-term capital gains, you're dealing with a much lower tax bracket than you might imagine.
Consider a single person who is considering a Roth conversion. They are taking the standard deduction in 2022 with $54,725 of ordinary income and $500,000 in qualified dividends. The ordinary income fills the 0% bracket (standard deduction) as well as the 10% and 12% brackets. However, the Roth conversion is taxed at 22%, not 37%. Note that in this situation the additional income from a Roth conversion would also bump capital gains up from the 15% to the 20% (really 23.8%) bracket, resulting in the conversion actually costing 30.8%, not 22% or 37%. It may also affect phaseouts of deductions or credits in certain situations. It is usually easiest to do hypothetical situations like this with tax software to account for all this and to really understand the tax cost.
#3 State Tax Rates Matter, Too
You also want to consider the effect of state tax rates. If you are working in California (high tax rate) but plan to retire in Nevada or Texas (no state income tax), then deferring taxes until you are in a lower tax state makes a lot of sense. This would argue against doing a Roth conversion or Roth 401(k) contributions. Others might find themselves in the opposite situation.
#4 Favor Roth at Equal (or Similar) Tax Rates
Another important principle to understand is that you should favor Roth contributions (and conversions) if you expect to withdraw money at the same (or similar) tax rate in retirement as your marginal tax rate at the time of contribution. Why are you better off with Roth? Because when you use a Roth account, all the money is in a Roth retirement account, where growth is not taxed each year as it occurs. When you use a traditional account, some of the money is in a traditional retirement account where growth is not taxed each year as it occurs and some of the money is in a taxable account where growth IS taxed each year as it occurs—at least any growth distributed as capital gains or dividends.
Let's use an example to wrap your head around this concept using a Roth conversion (although it works similarly with 401(k) contributions). Assume you have $10,000 in a traditional IRA and $3,500 in a taxable account and that you are in the 35% tax bracket.
Roth Conversion
If you do a Roth conversion, you move the $10,000 into a Roth IRA and pay $3,500 in tax. You now have $10,000 in a Roth IRA. It grows at 8% for 30 years and you end up with $100,627 after-tax.
No Roth Conversion
If you do not do a Roth conversion, you have $10,000 in a traditional IRA and $3,500 in a taxable account. The traditional IRA grows at 8% for 30 years and you end up with $100,627 pre-tax. After paying 35% on the withdrawal, you end up with $65,407. The taxable account, meanwhile, grows at 7.6% to account for tax drag. After 30 years, it is worth $31,509. You then pay 23.8% in capital gains taxes on the growth, leaving you with $26,390 after tax. Total is $65,407 + 26,390 = $91,797.
Thus, when tax brackets are equal, you are better off with the Roth conversion or Roth contributions because more of the money enjoys tax-protected growth.
How much lower can the tax bracket be in retirement, and you still come out ahead with the Roth conversion? Well, it depends on your assumptions, especially the length of time between contribution and withdrawal (while that money is benefitting from tax-protected growth). But with our 30-year example, the break-even difference in tax rate is about 9%, i.e., even if you paid 35% on the conversion and later took out the money at an average tax rate of 26%, you would still break even.
This WCI model is 6 going on 15. Can you tell?
#5 Pay for Conversions with Taxable Money Whenever Possible
The above example illustrates the importance of paying for a Roth conversion with taxable money (and preferable without incurring any capital gains taxes to access it) rather than tax-deferred money. Without that factor, it makes less sense to do a Roth conversion at all.
Again, consider a Roth conversion, but use the tax-deferred account to pay for the tax bill.
No Roth Conversion
If you do not do a Roth conversion, you have $10,000 in a traditional IRA. It grows at 8% for 30 years and you end up with $100,627 pre-tax. After paying 35% on the withdrawal, you end up with $65,407.
Roth Conversion
Now, let's say you want to do that Roth conversion, but the only money to pay the tax must come out of the traditional IRA itself. How much can you convert? Well, you have to pull out the 35% to pay the tax bill plus you have to pull out the 10% penalty for the early withdrawal. After a little algebra, X + 0.35X + 0.1 * 0.35X + 0.1 * 0.1 * 0.35X + 0.1 * 0.1 * 0.1 * 0.35X = $10,000 which simplifies to about 1.39X = $10,000, you find that you can convert $7,194. You'll end up paying $2,806 in tax and early withdrawal penalties. After 30 years, that $7,194 grows to $72,391. You (perhaps surprisingly) are still coming out ahead for doing the Roth conversion. But it does not take as large of a tax arbitrage to eliminate that benefit. If you could have withdrawn at an average rate of just 28% (instead of 26% if you had paid taxes from outside the account), you would come out even.
If accessing that taxable money will require paying taxes you otherwise would not have to pay, that could eliminate this benefit. Honestly, though, this issue is not as big of a deal as I thought it was until I ran the numbers. Most of the time, if a Roth conversion makes sense when paid for with taxable money, it will still make sense if paid for with tax-deferred money, especially after age 59 1/2 when the 10% penalty goes away.
#6 Who Will Spend the Money?
Another really important factor comes down to who will spend the money. As mentioned in point #1, it's really all about the comparison of the tax rate at contribution to the tax rate at withdrawal. But so far, we've been assuming YOU will be the one paying the taxes at withdrawal. There are several other options that could occur:
- Your heir, in a much higher tax bracket, pays the taxes
- Your heir, in a much lower tax bracket, pays the taxes
- A charity “pays” the taxes (i.e., no taxes are paid)
In the first scenario, that Roth conversion is going to work out very well in terms of the overall tax burden. In the second, the Roth conversion will not work out very well at all. In the third scenario, the Roth conversion would be a disaster since the charity would not pay any taxes at all if left tax-deferred money. If you will be leaving money to charity, it makes a lot of sense to preferentially leave tax-deferred money.
Since Katie and I plan to leave a substantial portion of our estate to charity (a larger amount than we will ever have in tax-deferred accounts), Roth conversions (and contributions) really don't make any sense at all for us from a tax standpoint alone.
However, there are additional benefits to Roth conversions besides just being a tax arbitrage. In most states, IRAs, including Roth IRAs, receive substantial asset protection, so when you “move money into” retirement accounts by paying the tax on a Roth conversion, more of your money is protected from your creditors by your state exemption. Retirement accounts also pass outside of probate thanks to the ability to name beneficiaries. In addition, if you are wealthy enough to have an estate tax problem, Roth conversions help reduce the size of your estate subject to estate taxes.
#7 Roth Conversions Reduce RMDs
Starting at age 72, investors must begin withdrawals from their traditional IRAs and 401(k)s (including Roth 401(k)s). These are Required Minimum Distributions (RMDs), and there are huge penalties for not taking them (50% of what you should have taken out). Even if you don't want or need the money, you must remove it from the IRA and reinvest it in a non-qualified/brokerage/taxable account. When you do a Roth conversion (at least into a Roth IRA), RMDs are no longer required, and that money can continue to grow tax-free for you and/or your heirs.
#8 Split the Difference?
Some people just aren't sure what to do when it comes to Roth vs. traditional 401(k) contributions or doing a Roth conversion. However, this is not an either/or decision. You can always split the difference, making half your contribution tax-deferred and half tax-free (or doing half of your potential Roth conversion). The upside is that you know you will have done the right thing with half your money. The downside? You also know you will have done the wrong thing with the other half.
Personally, I prefer trying to guess which is right and just doing that, but I'd be a liar if I said I had never guessed wrong. Those tax-deferred Thrift Savings Plan contributions I made at 15% while I was in the military look downright stupid now that I expect to spend the rest of my life in the top tax bracket. To be fair, there was no Roth option, but in retrospect, I still should have converted it all to a Roth IRA the year I left the military.
Likewise, the Roth 401(k) contributions and Mega Backdoor Roth IRA contributions we've been doing the last couple of years might also have been “wrong” given our estate planning goals that we've more recently determined. This stuff is complex, so I don't blame anyone for just splitting the difference.
#9 Convert to the Top of a Tax Bracket
When doing a Roth conversion, you generally want to convert “up to the top of a tax bracket.” That is, if it makes sense to do a Roth conversion at 24%, you should convert as many dollars as you can at 24%. This obviously requires you to be reasonably accurate at projecting your taxable income for the year, but hopefully, you can do that to within a few thousand dollars by November or December. If your estimated taxable income was $250,000 (Married Filing Jointly, 2022), you could convert $90,000 at 24% but any additional conversion would be done at 32%.
#10 Conversions Are Even Better in a Bear Market
Bear markets are nobody's favorite, but they do present opportunities such as “buying low” and tax loss harvesting. Roth conversions are another bear market opportunity. If you have a $100,000 IRA all invested in stock index funds and the market tanks 30%, you now have a $70,000 IRA. Converting it to a Roth IRA at 24% now only costs $70,000 * 24% = $16,800 instead of $100,000 * 24% = $24,000. You've just saved $7,200 in taxes just for timing your Roth conversion well.
Should YOU Do Roth Contributions (or a Roth Conversion)?
Here is where the rubber meets the road. The answer—like most things in law, accounting, and finance—is that it depends. It depends on many factors, some of which you know, some of which you don't know, and some of which you cannot know. These include:
- How long you will work
- How long you will live
- How much you will spend in retirement
- How much money you will have in retirement
- What types of income you will have in retirement
- Who you leave your money to
- The tax brackets of your heirs
- Whether your heirs will stretch an inherited IRA for 10 years
- Whether the government changes tax rates and in which direction
See what I mean? It's complicated. If you want to try to figure it out for yourself, the best place to start is to estimate how much taxable income you will have in retirement and see which brackets that income is likely to fill. Then, compare your marginal tax rate in retirement to your marginal tax rate now, recognizing that if it is close, it favors Roth contributions/conversions.
However, when things get complex, most people prefer to use rules of thumb. They're quick and easy and work most of the time.
Rules of Thumb for Roth Contributions and Conversions
Let me go over a few of these. Note that all of these have exceptions, so don't nitpick me. They work most of the time.
#1 Peak Earning Years = Tax-Deferred
This is the rule of thumb I've been using for years. The typical high-income professionals that are the target audience of this blog are in the 24%, 32%, 35%, or 37% brackets during their peak earning years. Most of them are married and retire on Social Security (perhaps $40,000-$60,000 per year) and with a nest egg of $2 million-$5 million, mostly in tax-deferred accounts. In that situation, their typical retirement taxable income is between $100,000-$220,000, basically the 22% bracket. So if they do tax-deferred contributions and save 32%, 35%, and 37% during their peak earning years and then mostly withdraw that money at 12% and 22% (0%, 10%, 12%, and 22% prior to taking Social Security), they're going to come out way ahead.
The reverse of this rule of thumb is also true. In any year when you are not at your peak earnings such as:
- Medical school
- Residency
- Fellowship
- The year you leave training
- A year with extended parental leave
- Sabbatical
- Part-time work
it makes sense to make Roth 401(k) contributions and also do some Roth conversions. The main exception? Going for Public Service Loan Forgiveness (PSLF). Tax-deferred contributions in that situation result in a lower taxable income, lower IDR payments, better cash flow, and more forgiven via PSLF.
#2 High Retirement Income Earners Should Favor Roth
If you expect to have a very high taxable income in retirement, you should (almost) always favor Roth contributions/conversions. Basically, if you will have enough taxable income from any source (except qualified dividends/long-term capital gains) to put yourself into the top three brackets (32%, 35%, or 37%) in retirement, you should (almost) always use Roth accounts preferentially—even if you are paying 37% on the contribution/conversion. The 32% bracket currently [2022] starts at $340,100 married but just $170,050 if you are single. And remember that unless you die the same year your spouse does, one of you will be single at least for a while. Sources of taxable income in retirement include:
- Social Security (85% of it will be taxable for most of this blog's audience)
- Pensions
- Tax-deferred withdrawals
- Interest
- Ordinary dividends
- Real estate rents not covered by depreciation
If you will have $182,000-$364,000 (top of 24% bracket + standard deduction) of taxable income from these sources in retirement, favor Roth.
#3 Supersavers Should Favor Roth
A major exception to the “tax-deferred in peak earning years” rule of thumb is a supersaver. If you save so much of your money that you are likely to be in a higher tax bracket in retirement than you are in your peak earnings years, then it makes sense to favor Roth contributions/conversions even in your peak earning years. This can be more a reflection of career length than of savings rate, however. Note that this also requires a somewhat tax-inefficient retirement income strategy. If your income is going to be predominantly qualified dividends, long-term capital gains, and basis, even a supersaver may still be better off with tax-deferred contributions during peak earning years.
#4 Very Charitable Folks Should Favor Tax-Deferred
The more you will give to charity during your retirement years and at your death, the more you should favor tax-deferred. If you will be giving more to charity than you have in your tax-deferred accounts—and especially if you are not going to be paying estate tax—there is no reason to do Roth conversions or contributions. You will leave more to charity/heirs by not going down the Roth route.
Roth conversions and contributions have lots of advantages. These include investment, tax, estate planning, and asset protection advantages. If you are afraid of high RMDs, the solution is not to avoid retirement accounts but to make Roth contributions and conversions. Nearly every white coat investor should seriously consider both Roth conversions and Roth 401(k) contributions (in addition to Backdoor Roth IRA contributions) at certain points of their lives, particularly any year that is not a peak earning year.
What do you think? Are you doing Roth conversions and/or Roth 401(k) contributions? Why or why not? Comment below!
I did a little bit of Roth while in school but all tax-deferred while working (have access to a 403b, 457 and an ORP times 2 (husband also)). Likely the right choice in terms of tax optimization but my primary motivation was to get to a million in retirement savings before 40.
I know that the dollars in a tax-deferred account are worth less but the psychological aspect of seeing that balance was important to me. Once I hit it, then I started thinking through the tax optimization a bit more. Same conclusion but different motivation.
Jim emphasizes that there are many factors in Roth conversions — agreed!
I am of the opinion that tax rates will rise — either with the impending 2026 end of the current tax rates, by the unlikely but possible other tax increases (wealth tax?), or by the very gradual effect of higher RMD withdrawal rates pushing one into higher income brackets. What pushed me ‘over the line’ in favor of conversions was the expectation that one spouse probably will outlive the other by 5 to 10 years — throwing that spouse into the single tax category with its lowered bracket amounts.
Of course, nothing in this conversation is simple. Tax rates may rise – but not as much as I fear. And the death of a spouse will reduce income from social security – mitigating the single tax bracket issue. And federal tax rates can be mitigated by a move to a tax-friendly state.
Overall, I am a ‘worrier’ — so I give more weight to the rise in taxes, the rise in RMDs and the thought of a spouse’s death in my equation for roth conversions. Therefore, I favor conversions. I don’t go overboard, however. I ‘fill-up’ my tax bracket of 24% each year with conversion amounts — taking advantage of stock market drops to convert temporarily (I hope) depressed stock prices.
Lots of people worry about higher tax rates. Those folks should actually sit down and define what they mean by higher tax rates and then run the numbers with those rates. Many will find that even if the higher rates they expect come to pass they are still better off deferring. Best to make the best assumptions you can and run the numbers than just guess or act out of fear.
Yes — run the numbers!!!
I (the ‘tax worrier’) used excel to model a scenario where a spouse died 5 years after a conversion. Income was REDUCED by the loss of SocSec, and the tax rate INCREASED due to the Singles brackets. Result? Breakeven for using outside funds to pay the roth conversion taxes was reduced, as expected — but only by a year or so — much less than I ‘feared’.
So quantify your variables and run the numbers!
As a 55 y/o FIRE’d retiree, I sneak into the 22% bracket on my inflation indexed pension income alone. Since I have no “earned” income, I can’t make IRA contributions, so starting the Roth conversion process allows me to make “contributions” (the tax I am paying) into my Roth IRA using my taxable accounts.
Add in my RMD “problem” if I don’t convert, it seems an easy decision for those of us in the #2 Rule of Thumb category above (even at a 22% or 24% bracket currently). I have started by filling up the 22% bracket and will see what happens to my Traditional IRA balance. If it continues to grow, I may even convert some in the 24% bracket as I also believe federal income tax will be going up for those making 6 figures (in today’s dollars) in the not so distant future. Even if that doesn’t happen, #4 princple would apply (converting at equal tax rates).
As always, I welcome any thougths on flaws in my logic.
The below article made me look twice:
This CPA is recommending Cash value life insurance as a good investment if Roth conversions go away for high-income earners!
[Entire article removed as it represents a copyright violation.]
You’re aware the authors of that article sell life insurance for a living, right? Kind of a major conflict of interest.
But the point stands that life insurance looks relatively better if Roth conversions go away. That still doesn’t make it a good investment. You can always invest in taxable.
The NIIT will sneak up on you if you don’t watch out. This kicks in at $250000.
Yes, as will many other phaseouts.
Excellent! Excellent! Excellent! This is the absolute best analysis I have seen on Roth related accounts and conversions. The general advice one sees in the personal finance space is to save in Roth accounts and do Roth conversions. As you have so well articulated, marginal tax rates pre and post retirement, RMDs and income sources are critical factors in making a decision. And lets not forget the impact on IRMA brackets. And who amongst us was prescient in 2015 that marginal tax brackets would be lower in 2017 and going forward?
Keep up the great work.
Thanks for your kind words.
Lange told me to Convert up to the top of the 24% bracket
Assuming GOP takes over Congress, they will make the tax cuts permanent
in FLORIDA a 400k income is an effective tax rate of 21%!!!!!
Thanks for the excellent analysis.
It might me that the half conversion strategy could be more than half right if you reduce the RMD thus stay out of the higher brackets in retirement. As my numbers firm up will certainly do some math to confirm my gut feel – of not.
Not so fast, my friends..
Delayed gratification is a cost for Roth converters. Say you spend $150,000 annually. Now fill to the top of 22% bracket with gifting, travel, home improvements, automobiles, restaurants, performing arts. You get the picture. None of us knows tax rates or investment returns 20-30 years out. Most of the above calculations are longer than my lifespan. Heirs may not be in a higher bracket for lots of reasons some of which we can only guess. Health related problems are possible for taxpayers and their heirs making tIRA more tax efficient. Someone above used the word prescient, but who among us has this power? I use conversion as a tool but no tree grows to the sky.
Lange says to fill up the 24% bracket
Tax rates will never be lower
I don’t think that if Lange said that he meant it as general advice that one should always convert up to the 24% bracket and never above. Nor do I think he would agree with your statement that tax rates will never be lower. I suspect you said that prior to 2017 too.
I am retired, with a t-IRA based on roll over of my corporate Profit Sharing plan, currently valued in the low eight digits. I was eligible for Roth conversions, based on appropriate tax brackets for six or eight years. Roth conversions of $100,000 to $150,000 per year would have removed at most a little over a million dollars from my t-IRA, reducing my RMD by only about 10%.
What a great problem to have! What does your estate plan look like?
Thanks for this info Jim. Regarding #5, I have been contributing the maximum 19500 to my Roth i401k at vanguard for the past three years. I’m wondering if it’s a good time, due to the Bear market to convert this money to my Roth IRA? Assuming that I understand your math correctly and I would pay less tax on that conversion now than possibly when I convert a larger sum around retirement age. And I should pay for the conversion with taxable dollars? This is a similar idea as with TL harvesting. I must admit I saw Roth 401k and went for it not truly understanding how it plays out later. TIA
That’s called a transfer, not a conversion. It’s already Roth money. You can move it to a Roth IRA at any point without tax consequences, although it may require you to close the 401(k) to do it.
Ok great! So the money is exactly where it needs to be as I’m still in my peak earning years. I’m aiming for FIRE though and anticipate I will need to determine how I will fill in my brackets later. Thanks
Lots of fuzzy math make the argument to swing for the fences regarding Roth. $67 thousand grows to $70 thousand over 30 years. Return rate of about 1%. $600 thousand income workers being happy with life in the 22% bracket. Dr. Jim knows that biology makes 30 year projection difficult. Think of the individual noted above who has eight figures net worth. This individual could put away $500,000 per year in Roth. That’s 5% of his net worth. With the stock market increasing over the 30 years this person is unlikely to make a dent in stopping the increase in RMDs. Most of us live in the 22% to 24% tax bracket. IRMAA is also a “tax.” When the tax differential is small, making Roth conversions now and paying them out at higher tax rates later, the returns shrink. Also there is the issue that doing Roth conversions implies that to get to 30 years one really should not touch the Roth money instead it should be left to our heirs. To do otherwise would negatively impact the 1% return over 30 years since you would be drawing out at 5, 10 or 20 years instead. As I see it, there are two problems with this logic. First of all those of us who have low seven figure traditional Iras will have less of a differential between converting and withdrawing. Those of us who have the eight figure traditional Ira will unlikely be able to convert enough to make a dent in their net worth. Moreover it is doubtful that they could live on $100,000 per year as mentioned above. All told it does make sense to go up to the top of your current tax bracket but don’t expect a large increase in net worth 20 to 30 years out. When your traditional Ira falls to an amount that will give you your 4% per year required to live on, that might be a good place to stop. Some of us of course will not get there because of large traditional Ira‘s. Some of us may already be there and to not be swinging for the fences.
For many people with 8 figure IRAs, it makes sense to convert even in the top brackets. Thus, you’re not “limited” to such a small amount that it doesn’t make a dent. Nothing keeping you from doing a $5M conversion and paying $2 million in taxes on it if you want to do so.
I’ve struggled with this math and i think you are missing something. Isn’t your seed and basket analogy in number 1 incorrect because you are putting a higher amount of money into the Roth account since the taxes aren’t included in the limits? You would have to start with 12.5 seeds in the Roth example, and take 20% of that would get you the 10 seeds to start with and that would yield 4 extra baskets of fruit at a cost of 2.5 extra seeds. So 19,500 is really putting 27-28,000 in and then taking taxes so mathematically Roth would be favored because it actually allows more money into the accounts as long as paying the taxes fits your budget? Normally those 2.5 seeds would have produced 5 baskets but it seems like if you are putting even a small amount into a taxable each year then Roth would be favored so you you get more tax protected growth than taxable account growth.
The factor you are discussing has nothing to do with tax-free vs tax-deferred and everything to do with tax-protected vs taxable. It is discussed under principle # 4. For the seed/tree/fruit analogy assume you are not investing so much that something has to go into taxable.
Read Lange’s book Beating the Death Tax to see how he favors conversions almost universally
I’m aware he’s a huge fan. I mean, he is the founder of the Roth IRA institute. I just disagree that it should be done at all times.
In your principle #1 Use Tax Rates, Not Tax Paid, I don’t think they are the same.
You are paying taxes on the seed/tree, not the fruit.
In your example one, you are paying taxes on the seed (10).
In example two, you are paying taxes on the trees (10).
Tha tax bill in example two is much higher because your gains are tax free. The gains are the difference between 10 seeds and 10 trees You paid taxes on 10 seeds, and they gained to 10 trees. No taxes on the 10 trees.
What am I missing?
Maybe I confused things by using the seed/tree/fruit analogy. Forget the tree. You can pay taxes on the seed or the fruit. It doesn’t matter which, you end up with the same amount of fruit (after-tax money) in the end.
There is all this talk about choosing… However, aren’t you limited by what you can do? I have a 401k, mega back door Roth and a ira back door Roth. The 401k there is a choice… Is that what the discussion is about? I see no point in not converting the mega back door Roth or IRA as they are post tax anyways… So no cost to doing it. My wife has a 457 which does not have a Roth option. So is the whole discussion just for what to do with your regular 401k contributions?
For you? Yes. For others there may be other options.
“Likewise, the Roth 401(k) contributions and Mega Backdoor Roth IRA contributions we’ve been doing the last couple of years might also have been “wrong” given our estate planning goals that we’ve more recently determined. ”
As someone who is also doing megabackdoor Roth contributions (thanks to WCI) I would love to hear how this could go wrong!
We could have done tax-deferred contributions instead and then used those for charitable giving at death. Basically our financial plan even a few years ago did not anticipate our current level of income and wealth due to the success of WCI. So the assumptions used for decisions in the past turned out to be wrong and thus the decisions were wrong. Things could always change again and make those decisions turn out to be right in the end. It’s complicated.
Jim,
In your example #5, it seems as though your tax of $2806 is provided from the traditional IRA tax free. If you withdraw $10000 from traditional then tax is $3500 and penalty is $1000. Roth contribution would be $5500. At least that is how I see it. What am I missing?
You’re not withdrawing $10K. All you have to pay the penalty on is the money that is withdrawn. The only money withdrawn is the money to pay the tax and penalty. That doesn’t mean I did the math right (although I think I did), but it does mean your math is wrong.
Just to reinforce the message — for those looking at converting t-IRA to Roth up to a certain amount, don’t neglect marginal and effective tax rates.
I am recently retired and will likely have mid-6 figures in capital gains each year. No other income to speak of. When modeling out the impact of doing a conversion from t-IRA to Roth, if I fill the bucket to the top of the 24% bracket ($366k) it results in an effective tax rate of ~30% on the added income due to the conversion income having a higher effective tax rate than the same amount of capital gain income, the conversion income pushing the capital gain income into higher capital gain brackets, and the expanded application of NIIT to capital gain income.
Remember LTCGs and qualified dividends always come last in the “order of operations.” You fill the lower brackets with the conversion, not the LTCGs. But that can push the capital gains into higher brackets of course.
In principle #4, it’s interesting that “the break-even difference in tax rate is about 9%, i.e., even if you paid 35% on the Roth conversion and later took out the money at an average tax rate of 26%, you would still break even.”
Based on that, would an individual who converts an traditional IRA in this scenario (35% current bracket, 26% retirement bracket) therefore also be better off contributing to a Roth 401k instead of a traditional, deductible 401k?
The math works the same way.
I have 3 Roth IRAs (I know, I know, don’t ask). I backdoor contribute to only one and would like to combine the other 2 into this one to simplify things. Is it possible to do this, and if so, can it be done in the same year? I’ve read conflicting articles on this. Greatly appreciate any info or a point to a previous blog post, etc. Thank you!
Yes. Just roll them all into the same Roth IRA. No big deal. Contact your Roth IRA custodian and they’ll get you the paperwork. Easy peasy.
Any good excel calculators to help with this analysis. A couple of items I have been thinking of and need to factor into my calculations – We live in MN with a 6% state tax and will likely retire to a lower tax rate state. We are deferring all my wife’s income (~$200K) in an EDCP plan which we will have to take out during the 1st 10 years of retirement. The 1st item (MN taxes) would be a negative factor against converting and the 2nd would be a positive.
These sorts of calculations are all garbage in/garbage out and so many variables and assumptions an accurate calculator for all would be very difficult to make. For example, what number would you put in for future tax brackets? That’s different for everyone.
If the heir in a Higher tax bracket pays the taxes, that’s a bad mo.ve? What am I missing?
Better for you to do a Roth conversion now in a lower tax bracket than for them to later pay taxes at a higher rate.
I am addressing comment #8 where you state the following:
“Those tax-deferred Thrift Savings Plan contributions I made at 15% while I was in the military look downright stupid now that I expect to spend the rest of my life in the top tax bracket. To be fair, there was no Roth option, but in retrospect, I still should have converted it all to a Roth IRA the year I left the military.”
I am assuming you are referring to the 15% tax bracket that you were in when you made a contribution to a traditional TSP account.
It is not clear to me that you made a mistake when making these contributions. When doing an economic analysis you must analyze the options you actually had at the time. The only options you had at the time were Roth IRA, traditional TSP, or taxable account. Only one of these options get you the matching funds and they must be taken into account if the comparison is to be fair. I am ignoring the 1% for free as you get these funds no matter what decision is made.
Consider a choice between the traditional TSP and a taxable account. Lets say you contribute 3 dollars to your traditional TSP. You now have your $3 contribution plus $3 in matching funds in the account for a total of $6. If instead you decided to put your $3 in a taxable account you have (1- 0.15)3 = $2.55 in your taxable account. At this point things are looking grim for the taxable account. My question for you is did you take matching funds into account.
There were no matching funds back then either. But basically I deferred taxes at 15% that I am highly likely to pay later at something like 37%. Well, only for RMDs. The rest will probably go to charity honestly.
Retrospectoscope.