To Convert or Not to Convert:

The topic of Roth conversions is one of the top single-issue discussion points among financial planners and their clients. Perhaps the only other topic that competes with it at the same level of interest is when to claim your Social Security benefits. For both questions, the answer is not always obvious and requires an understanding of your personal situation and preferences.

When it comes to Roth conversions, I believe the answer to whether it’s a good idea for you boils down to your preferences for maximizing what you have now (i.e., bird in hand) vs. maximizing your long-term wealth (see example at the bottom of the newsletter). The problem is that for many, specifically those who are already in retirement, the concept of “long-term” can be an issue.

To give you a general example, would it truly make sense for an average 75-year-old to reduce her net worth by paying taxes on the conversion today to benefit from this strategy in the future? Well, it depends. And I can argue in both directions depending on the circumstances. This newsletter will not address this question for you personally, so my apologies if this was your expectation! Instead, I will share some useful guidelines that can be helpful for you to determine if you should actually spend the time to analyze whether this strategy works for you.

When Roth conversions are not likely to be a good choice:

• If you find yourself in the 32%, 35%, or 37% federal tax bracket, meaning you pay between 32 to 37 cents on each dollar of Roth conversion (plus state taxes), you should consider a different strategy. In fact, I can’t recall ever recommending a Roth conversion for our clients who are in these tax brackets. There are some reasons to do it even then, but that’s outside the scope of this newsletter.

• If you are a conservative investor and your converted funds are expected to grow at 3% to 5% per year, it’s going to take a long time to get your paid taxes back. So, if you are willing to wait 12 to 15 years to benefit from the strategy, that’s fine, but it’s a long time to wait.

• If you expect to have significant required minimum distributions (RMDs), think six-figure amounts each year, the Roth conversion analysis will often put you in a 32% or higher tax bracket (again, plus your state taxes). As I mentioned earlier, this is not likely to be a good choice for you unless you find yourself in a rather unique set of circumstances. As a rule of thumb, you would want to convert as much as possible prior to your RMD age, currently 73, and consider only small conversions beyond this point.

When Roth conversions can be beneficial:

• In situations when you find yourself in the 0%, 10%, or 12% tax bracket, meaning your income is below $48,000 for single filers or $97,000 for joint filers, Roth conversions usually make a lot of sense. One caveat. If you expect to remain in this set of brackets throughout your retirement, Roth conversions may not be that beneficial. Why pay even some taxes now if you are not expected to pay much in the future anyway? But, frankly, the situation I just described happens rather infrequently. If you have to pay so little today to hedge against the uncertainty in the future, why not take the risk?

• When the market is down, think post “Liberation Day” in April, a Roth conversion, even in a higher tax bracket, may make sense because any future growth is entirely captured in a tax-free account (i.e., Roth IRA). This type of planning is rather situational, but opportunities like that do happen every few years or so. You just need to be on top of your finances!

• Now, if you are over the age of 73 and already taking your RMD but are also inclined to make significant charitable donations (QCD) from your IRA, the Roth conversion can become beneficial to you again. Keep in mind you must take out your RMD before you convert any portion of your IRA into a Roth. You cannot convert your RMD!

• Where it really becomes interesting is if you focus on multi-generational planning.

Just to give you an example. Let’s say you managed to convert $100,000 into a Roth and paid $30,000 in taxes over a certain time period. If you never touch your Roth and your children inherit the account, they will not need to take any funds out until year 10 after inheriting your account.

An extra 10 years of tax-free growth is a big deal! If you are thinking about making financial gifts, your beneficiary would be more than happy to inherit a Roth IRA instead of many other types of assets.

• Finally, if you are an early retiree and you find yourself in a lower or mid-tier tax bracket, such as 22% or 24%, a multi-year Roth conversion can make a lot of sense for you.

So, what is a multi-year Roth conversion?

As the name implies, the idea is to create a plan to do conversions for more than one year, ideally for 10 years or even more. Here is a more specific example. One of our clients retired with $2.4M in his IRA at age 62. Over the next 11 years, we projected that he can convert $1.1M into a Roth, approximately $100,000 per year (the actual annual conversion amount will need to be adjusted each year).

This approach will cost him $320,000 in taxes over 11 years. Not a small amount to say the least!

On the other hand, his tax savings from age 73 to 95 are expected to be $593,000. But this is not the main benefit.

Since the growth in a Roth IRA is tax-free and not subject to annual RMDs, the total net worth with the multi-year conversion is expected to be $8.1M at age 95. This is in comparison to $4.6M at the same age without the conversions. So, we are talking about $3.5M of difference in the long run in future dollars. To be clear, when adjusted for inflation, the difference is “only” $1.3M in today’s dollars. Still, not too bad!

(Please note that I’m omitting many important details and variables from this example to simplify and illustrate my point. It’s entirely possible that a similar analysis for your specific situation would yield rather different results).

What does all of this mean to you?

Roth conversions are not a no-brainer, contrary to how some gurus portray them. So, don’t think of them as a magic bullet to solve your tax issues.

 On the other hand, if implemented thoughtfully and strategically over a number of years, they can significantly increase your net worth (or future inheritance if this is your goal).