I had a request recently to do a post on Roth Conversions. As many times as I have mentioned them on this site, I’ve never really written a post specifically about them. They’re not particularly complicated, however, the decision about whether or not to do one and how much to convert absolutely can be.
How to Do a Roth Conversion
Step 1 – Transfer money from your traditional IRA to a Roth IRA.
Step 2 – Pay taxes on that money.
That’s really all there is too it. Simple, no? There are a few variations. For example, you can transfer money directly from a 401(k) to a Roth IRA (and then pay taxes.) You can also, if the plan allows it, transfer money from a 401(k) to a Roth 401(k) or a 403(b) to a Roth 403(b) (and then pay taxes.)
Benefits of a Roth Conversion
There are a number of benefits of a Roth conversion.
- That money will never be taxed again (although estate or inheritance taxes could apply)
- No required minimum distributions on that money (not true in a Roth 401(k) or 403(b))
- If left to heirs, no income taxes for them either (better to inherit a Roth IRA than a traditional IRA)
- Assuming you’re using a taxable account to pay the taxes, you are getting more money, on an after-tax basis, into a tax-protected and asset-protected accounts. In essence, you’re transferring money from taxable to tax-protected.
- Done properly, you may be lowering your overall lifetime tax burden
- Smaller Required Minimum Distributions after age 70 1/2
- May reduce estate/inheritance taxes due by removing “the government’s portion” of retirement accounts from the estate
Downside of a Roth Conversion
There is really only one downside of a Roth conversion
- You pay taxes on it.
Did you get that? This isn’t like a backdoor Roth, where you’re comparing a taxable account to a Roth account. The Roth account always wins in that scenario. In this scenario, the Roth DOES NOT always win. In fact, it can be a pretty complicated decision.
When To Do A Roth Conversion
The idea behind a successful Roth conversion is that you want to prepay taxes at a lower rate than you would pay them later. Sometimes, there is another benefit, such as the ability to do a backdoor Roth IRA going forward (this occurs in situations where you cannot roll a SEP-IRA or traditional IRA into a 401(k) of some type.) So when are good times to do a Roth conversion of tax-deferred assets?
- As a student, resident, or upon residency graduation.
- During a sabbatical or other low income year
- While temporarily disabled (assuming disability income is tax-free)
- While in the military
- After cutting back to part-time
- In early retirement, before receiving Social Security
- When you have a particularly low Roth to tax-deferred ratio and desire more tax diversification
When are bad times to do Roth conversions?
- During peak earnings years.
- Using money you would give to charity anyway
- Using money you would give to heirs in a low tax bracket
- When you don’t have taxable money you can use to pay the taxes
- When you don’t have much of a tax-deferred account
Remember that in retirement, especially early retirement, you want to have enough taxable (i.e. tax-deferred account withdrawals) income to fill the 0%, 10%, and 15% brackets. So it’s silly to convert anywhere near ALL your tax-deferred money to Roth money.
How Much Should I Convert?
The general rule is that you convert up to the top of a certain tax bracket. That might be the 15% bracket or perhaps even the 25% bracket. Generally doing conversions above this amount isn’t advised, unless you expect a great deal of taxable income in retirement (and would be paying 28%+ on retirement income.) Practically speaking, what does that mean?
Consider this example.taxable accounts, and no Roth accounts. He has cut back to part-time and now makes $80,000 per year. This year he will begin maxing out a Roth 401(k) and personal and spousal backdoor Roth IRAs. His spouse does not work and they have about $20,000 in deductions/exemptions each year. He thinks a Roth conversion is a good idea for him, but is unsure how large of a conversion to do this year.
Let’s assume his tax-deferred assets grow from $2 Million to $2.5 Million at the time of his retirement. Let’s also assume that between him and his wife, they’ll get $50,000 a year in Social Security, 85% of which will be taxable. Assuming $20K in deductions/exemptions, his taxable retirement income will be around $122,500, squarely in the 25% bracket. Thus, it probably does NOT make sense to pay taxes at more than 25% now in order to do a Roth conversion. 25% makes sense for his situation (no Roth and plenty of taxable to pay the taxes.) 15% is a great deal.
His current taxable income of $60,000 is well within the 15% bracket. The first $12,900 he converts this year will be done at 15%. That much is a no-brainer. It would probably be advisable for him to convert another $76,300 (filling the entire 25% bracket) this year as well. That conversion will cost him $12,900*0.15 + $76,300*0.25 = $21,010. He can certainly afford that given the size of his taxable account. Between his Roth 401(k) contributions, his backdoor Roth IRA contributions, and his Roth conversion, (and probably spending some of the taxable money) he will rapidly be converting taxable assets to Roth assets, a great financial move. If he does this sort of thing 5 years in a row or so, he will have pretty nice tax diversification throughout retirement due to a sizable Roth account.
In short, Roth conversions can be a great tool, but run the numbers first. Roth does NOT always win this competition.
What do you think? Have you done a Roth conversion? Why or why not? Do you anticipate doing some in the future? Comment below!