By James B. Twining, CFP® and Tor Benson, CFP®

The decision to make a Roth conversion can be extremely impactful, warranting thorough, professional analysis with consideration of all pertinent factors.

If current and future assumed tax rates are equal, a Roth conversion is often assumed to be neither beneficial nor detrimental.  

Appendix A illustrates a simple comparison that illustrates this concept.  

Appendix B illustrates the benefit of Roth conversions if future rates are higher than the current, and the detriment if they are lower. 

While the comparison between current and assumed future tax rates is a good place to start when debating a Roth conversion, the analysis cannot end there. 

In this article, I identify nine factors, each of which can favor a Roth conversion, depending upon the individual circumstances. In some cases, the factors are weighty enough to make a Roth conversion beneficial even when future assumed tax rates are significantly lower than current rates. 

Appendix D contains a case study that illustrates an example in which this is the result.

Download a Complimentary Copy Of Our Guide, “Nine Factors That May Favor a Roth Conversion.”

Nine Factors That May Favor a Roth Conversion

These nine factors apply to a varying degree depending upon the individual case. The advantages of each are additive, and in most cases the compounded result is significant. The nine factors are:

   1)   tax debt and the resulting tax risk within traditional IRAs

   2)  current taxation of earnings within taxable accounts

   3)  funds transformed from tax-favored to currently taxable treatment due to Required Minimum Distributions (RMDs)

   4)  increased effective tax on RMDs for a single filer after the death of a spouse

   5)  taxability of Social Security Benefits resulting from RMDs 

   6)  taxability of capital gains resulting from RMDs 

   7)  Income-Related Monthly Adjustment Amount (IRMAA) payments on Medicare premiums resulting from RMDs 

   8)  Affordable Care Act (ACA) medical insurance premium increase due to traditional IRA withdrawals

   9)  disqualification from property tax reductions resulting from RMDs

 

Following is the rationale for each factor:

1) Tax debt and the resulting tax risk within traditional IRAs

A traditional IRA is funded with earnings that have yet to be taxed. That unpaid tax is a debt. It does not incur an interest cost like a typical debt but does create uncertainty as to what the future tax bill will be. The taxpayer who converts pays tax at a current, known bracket, and avoids paying taxes in a future, unknown bracket. Future tax rates are dependent on:

1) the future income profile of the taxpayer and 

2) future tax law

Although the future income profile of the investor can often be assumed, future tax law is unknowable. A Roth conversion eliminates the risk that the future taxes may be higher by paying the tax debt now. However, it causes a different risk: that future tax law will result in lower tax brackets, or a complete repeal of the income tax in favor of a federal VAT or consumption tax. Regardless, most observers would opine that given our federal fiscal and monetary policies, it is more likely that income tax rates will rise. The only way to determine the tax liability with precision is to settle it now through a Roth conversion.

If the sole alternative to tax deferral in the traditional IRA were a currently taxable account, the traditional IRA would be a good option, regardless of tax risk. After all, it is tax deferral that makes traditional IRAs beneficial in the first place. However, the Roth option causes all future earnings, growth, and withdrawals to be tax free and eliminates tax debt and tax uncertainty, making it a superior alternative in many cases.

This factor cannot be quantified, but many cautious investors will gain peace of mind through the realization that due to a full Roth conversion, they are free of tax debt and future tax uncertainty.  

2)  Current taxation of earnings within taxable accounts

When a Roth conversion takes place, taxes are due on the converted amount. Paying those taxes from the IRA itself through withholding an additional amount accelerates the tax on that amount; and these amounts represent funds that will not enjoy future Roth status. For this reason, it is advantageous to pay the tax from a taxable account instead. Roth conversions will not often be effective unless there is a sufficient balance in taxable accounts with which to pay the tax.

When tax on a Roth conversion is paid from a taxable account, it reduces the taxable account balance, and this reduces the annual taxation of interest, dividends, and capital gains. This factor favors the Roth conversion. How much it tips the scales depends upon a few variables. Ask yourself these questions:  

1. Does paying the tax on the conversion make sales of appreciated securities necessary? If so, the difference may be eliminated by current capital gains taxes. 
2. Is the taxable account invested in mutual funds that pay out capital gains distributions? If so, the advantage will be greater than if the account is invested in equities or ETFs that do not pay capital gains distributions. 
3. If the taxable account contains bonds, are they taxable or tax- free municipal bonds? The difference will be greater if the bond interest is taxable.

Calculations that use reasonable tax assumptions for tax basis of the taxable account and taxability of bond interest, dividends, capital gains distributions and realized gains will capture the advantage of Roth conversion related to this factor.

3) Funds transformed from tax favored to currently taxable treatment as a result of RMDs

Traditional IRAs have Required Minimum Distributions (RMDs), while Roth IRAs do not. When comparing the tax favored status of the traditional versus a converted Roth IRA, RMDs effectively reduce the traditional IRA funds which qualify for tax favored status over time, transforming them into funds that receive “currently taxable” treatment. 

If the tax on a conversion is paid from a taxable account, the beginning Roth IRA balance is identical to that of the traditional IRA upon conversion. <https://financialplaninc.com/roth-conversions-underutilized/#appendix-c>Appendix C illustrates a comparison of a traditional IRA that is subject to RMDs to a converted Roth IRA that is not. By life expectancy, the Roth IRA balance is much higher than the traditional IRA balance. This increases the tax favored status of the Roth compared to the traditional IRA.

Note that the total RMDs of $1.26 million from the traditional IRA over the lifetime of the taxpayer may not be converted to a Roth IRA, and therefore are invested into a taxable account, aggravating the impact observed in factor 2 described above. If the investor has a need to spend the entire RMD net of tax each year, it must be assumed that after a conversion, those same net amounts would be withdrawn from the Roth IRA. In that case, the reduction in funds qualifying for tax favored status will still be lower in the traditional IRA because tax withholding will be required on traditional IRA withdrawals which increases the gross withdrawal amounts.  

4) The increased effective tax on RMDs for a single filer after the death of a spouse

In the case of a married couple filing jointly, the favorable, married brackets are available only until the first death. After the first death, the survivor will pay tax in the higher single brackets.  In a no-conversion scenario, all RMDs after the first death are subject to increased taxation. In the Roth conversion scenario, all the taxes were previously paid in the favorable married brackets.  

In situations where much of the marital income is reduced upon the first death – for example, a large single-life pension, this factor may be offset. However, if much of the income will continue after the first death, this will favor a Roth conversion. In most cases, the tax on RMDs will roughly double after the first death.

5) Taxability of Social Security Benefits resulting from RMDs

The taxability of Social Security depends upon the amount of “provisional” income. Provisional income is equal to:

Gross income excluding 50% of SS income less some adjustments

+          Tax free interest

=     Provisional Income

 

For low-income taxpayers, Social Security is non-taxable. As provisional income increases, so does the portion of Social Security benefits that are taxable, to a maximum of 85%.

RMDs from traditional IRAs are often the cause of Social Security benefit taxation. Conversely, after a full Roth conversion, if there are no other major sources of income, Social Security benefits are tax free. For example, a retired couple with $100,000 per year in Roth IRA withdrawals and $60,000 in Social Security benefits will pay no tax. If instead they had $100,000 withdrawals from a traditional IRA and $60,000 in Social Security benefits, they would pay tax not only on the IRA withdrawals, but also on 85% of the Social Security benefits.

This factor often tips the scales in favor of a Roth conversion, and it also can make a one-time full conversion more effective than annual partial conversions, as the one-time conversion affects Social Security taxation only in the year of the conversion, whereas partial conversions over the course of multiple years often increase Social Security taxation in every year in which the partial conversions take place.  

6) Taxability of capital gains resulting from RMDs

Long-term capital gains tax rates are lower than ordinary rates, and in the lower tax brackets, they are not taxed at all. For example, a married couple with a taxable income of $60,000 with an additional $30,000 in capital gains will pay no tax on the gain.  

RMDs add to taxable income each year and can cause capital gains to be taxable. A full Roth conversion eliminates RMDs and often causes capital gains in future years to be tax free.  Partial Roth conversions can accomplish the same thing if the converted amounts are low enough to result in a 0% long term capital gains bracket. The realization of capital gains can be avoided in conversion years; deferred to the following years in which they will be tax free. 

7) IRMAA on Medicare premiums resulting from RMDs

When Modified Adjusted Gross Income (MAGI) reaches a certain threshold, Medicare Part B and D premiums are adjusted upward two years later. These increases are called Income Related Monthly Adjustment Amounts (IRMAA). For example, a married couple with MAGI over $194,000 will pay additional premiums over the base amount. As MAGI increases further, the Medicare Part B premiums continue to increase to a maximum of $560.50 per month per person, as compared to the base premium of $164.90. For a married couple, the annual difference can be as high as $11,327 when Medicare Part D adjustments are included. 

RMDs from traditional IRAs add to MAGI and contribute to these upward adjustments to Medicare Part B and D premiums. A Full Roth conversion made before age 63 may avoid any IRMAAs and if made at age 63 or later will cause these higher premiums for only one year. For every subsequent year, MAGI will be lower than if the Roth conversion had not taken place, and this is a contributing factor that reduces Medicare premium IRMAA adjustments. This can tip the scale in favor of Roth conversions.

8) ACA subsidies reduced as a result of traditional IRA withdrawals

This Affordable Care Act (ACA) factor affects only those who are not yet on Medicare. For example, a Washington State couple residing in the 98226 zip code who earns less than $120,000 MAGI would start to be eligible for premium tax credit subsidies, which reduce the amount they pay for health insurance through the ACA exchange. The amount of premium tax credits available is based on a sliding scale of MAGI, with people earning less money receiving more assistance. The lower the income, the higher the subsidy.  

The elimination of future traditional IRA withdrawals resulting from a full Roth conversion will reduce future MAGI and increase the ACA subsidies. This can make Roth conversions advantageous for those who are on the ACA exchange. In the year of the conversion, the ACA subsidies will be reduced, but this is a small price to obtain annual subsidies in future years.

9) Disqualification from property tax reductions resulting from RMDs

This factor comes into play for senior citizens who have a yet lower income level. In many jurisdictions, taxpayers with low income are exempt from a portion of their property tax. For example, in Whatcom County, Washington, a homeowner age 61 or older with a “combined disposable household income” of $45,000 or less receives a partial exemption from the payment of property tax. Combined disposable household income includes retirement plan withdrawals, but only if they are taxable, meaning that traditional IRA withdrawals are included but Roth IRA withdrawals are not. Once again, this factor favors Roth conversion for those who will qualify for a property tax exemption with a reduction in RMDs.

For lower income seniors, a small partial conversion is often preferable to a large conversion because this is often all that is necessary to qualify for the property tax exemption, and the RMDs can be small enough to result in a very low tax rate.

Summary

Few investors can take advantage of all nine factors outlined above, but all will benefit from some combination of them. In some cases, the combined factors are significant enough to make a Roth conversion beneficial, even if the future tax rates are assumed to be lower than the current tax rate that applies to the conversion.  

A full Roth conversion provides the clearest, simplest illustration. However, leaving a small portion in the traditional IRA is often more advantageous if the remaining RMDs are low enough to avoid contributing to the factors outlined above.

The benefits of Roth conversions do not end with the account owner; there are additional factors that can benefit non-spouse beneficiaries such as: 

1. The 10-year rule, which tends to concentrate traditional IRA withdrawals into a limited time frame, increasing tax brackets, and 
2. The 10 years after death of the account owner to consider, which magnifies the benefit of tax-free Roth status for the beneficiaries.     

Understanding and applying the factors outlined herein will result in more and larger Roth conversions taking place, with a corresponding increase in client wealth, whether spent during life or bequeathed to the next generation. 

As Roth conversions cause a current decrease in assets under management due to taxation, it is imperative for legal fiduciaries to do their duty. The non-fiduciary investment industry at large must guard against self-serving, and in fact, this conflict of interest may be a contributing factor to the deafening silence on the significant benefits of a Roth conversion. 

I, for one, will shout it from the rooftops: “Convert, O ye of little faith!

Disclosure:

Each individual investor has a set of unique circumstances. The concepts articulated herein are not meant to be used as specific advice for any singular client situation. Only through careful analysis performed by an experienced professional who is well versed in these matters can an optimal decision be made. These concepts do not imply that Roth conversions are always the best choice; there are many situations in which the proper decision is not to convert. Please rely upon your financial advisor to facilitate your decision as to the benefit of a Roth conversion, and the amounts and timing of such conversions.

 

Appendix A:

Roth conversions are a popular technique for investors who believe their future tax rates will be higher than they currently are. A young investor who is not yet in the peak earning years, and who is accumulating large traditional retirement accounts such as 401(k) and pensions may expect to be paying tax in higher tax brackets throughout the working years and even after retirement. Likewise, a retired investor who is withdrawing principal from taxable accounts while leaving traditional IRAs alone to grow tax deferred may be in a very low current bracket and is anticipating higher taxes in the future once required minimum distributions begin. In cases such as these, Roth conversions are clearly beneficial. The tax on a modest conversion is paid in today’s low bracket, and in return the future tax in a higher bracket is avoided.  

Roth conversions are less popular for investors who are currently paying a high tax rate. The investor who is in the peak earning years and who anticipates a lower bracket after retirement will avoid a Roth conversion. Those who are unaware of the factors outlined in this article may naturally assume that it is detrimental to pay tax on a conversion now in a high bracket, when by waiting, the funds can be withdrawn later from the traditional IRA in a lower bracket.

To illustrate the common logic which ignores all the nine factors, here I assume an investor with a starting balance of $100,000 in a traditional IRA and $100,000 in a taxable account. The holding period is ten years, and the annual rate of return on both accounts is 7%. The effective tax rate on the converted amount is 37% now, and the same 37% effective rate is assumed in ten years. I illustrate the results of 1) no conversion, 2) a $50,000 conversion, and 3) a full $100,000 conversion. Note that the result is an identical $320,646 in terminal after-tax assets regardless of the amount converted:

Appendix B:

What is the result of a Roth conversion if the future tax rate is lower than the current 37% rate?  Predictably, the lower future tax rate results in higher terminal assets in the no-conversion scenario. A lower future effective tax rate of 25% increases terminal assets in the no-conversion scenario to $344,251, making a Roth conversion detrimental:

Conversely, a higher future effective rate of 50% reduces terminal assets of the no-conversion scenario to $295,073, making a Roth conversion beneficial:

Appendix C:

Here we compare a Traditional IRA to a converted Roth IRA, illustrating the impact of RMDs on the Traditional IRA balance. Note that the tax on the Roth conversion does not reduce the initial Roth IRA balance, as it is paid from a taxable account. The accumulating taxable account balance is omitted here, as it does not affect the tax-favored balance, which is the sole issue here. The terminal tax-favored balance is nearly $2.2 million greater in the conversion scenario.

Appendix D:

Case Study

Assumptions:

Retired Married Couple:

   Bo, age 65, assumed life expectancy age 76

   Sally, age 63, assumed life expectancy age 92

Assets:

    Traditional IRA, Bo, $3 million balance

    Joint account, $2 million balance

Income:

      Social Security, Bo, beginning now at age 65, $40,000

      Social Security, Sally, beginning at age 62, $30,000

Expenses:  

       Living expenses $70,000; 25% reduction after 1st death

Investment Assumptions:

       All accounts rate of return 6.6%

       Excess cash assumed to be invested at 6.6%

 Tax Assumptions; Percentage of Annual Increase:

       57% capital gains; 3% realized annually 

       26% ordinary dividends and interest

       17% qualified dividends

Goal:

       To determine if a full Roth conversion in year 2 would result in increased after-tax terminal 

       assets.

Comments:

       A $15 million withdrawal of funds in 2048 captures almost all the tax on the traditional IRA, 

       converting that value into an after-tax balance. Only after deducting the tax can a fair

       comparison be made to the Roth IRA. Because less than 100% of the traditional IRA is 

       withdrawn, the benefit of the Roth conversion is slightly understated.

Result:

       Even though the full conversion is taxed at an effective rate of 34.17%, and in no future year 

       does the effective rate rise beyond 26.78% if no conversion takes place, the Roth 

       conversion scenario results in an increase of terminal after tax assets of over $5.2 million.

Six of the nine factors contributed to this result:

2)  current taxation of earnings within taxable accounts

3) funds transformed from tax favored to currently taxable treatment due to RMDs

4) increased effective tax on RMDs for a single filer after the death of a spouse

5) taxability of Social Security Benefits resulting from RMDs 

6) taxability of capital gains resulting from RMDs 

7) IRMAA payments on Medicare premiums resulting from RMDs 

 

The other three factors had no measurable impact:

1.Tax debt and the resulting tax risk within traditional IRAs. The reduction in tax debt and tax risk is not measurable.

8. ACA medical insurance premium increase due to traditional IRA withdrawals. Bo is already covered by Medicare, and Sally, at age 63, is only two years from Medicare age. Any potential advantage would be unlikely and has not been included.

9. Disqualification from property tax reductions resulting from RMDs. No property tax reductions were included, as these would be unlikely, and vary with the locale.

Here we quantify the Roth conversion advantage, expressed as the increase of over $5.2 million in terminal assets at life expectancy: 

A large portion of the advantage is a result of reduced income taxes. Over the entire period, if no Roth conversion takes place, the total income taxes paid are nearly $5.8 million. With the Roth conversion, they are just under $1.7 million. Although the Roth conversion scenario accelerates the tax, that factor is not nearly enough to offset the large reduction: when the taxes on the no-conversion scenario are discounted for 3% inflation, they equal over $3.1 million in present value, still over $1.4 million more in tax than in the Roth conversion scenario.  

In the no-conversion scenario, the taxable account grows to over $9.3 million, whereas in the Roth conversion scenario, it grows to just over $3 million. The higher taxable account balances over the years result in increased taxation compared to higher Roth IRA balances.

Totals                                                                                                                                                   $5,793,262                                                                                                                                    $1,694,970

Present Value at 3% Discount rate                                                                                                $3,138,678

These straight-line projections do not account for variability of returns. A Monte Carlo simulation does, and it shows that the probability of success (defined as the ability to meet the living expenses and the $15 million withdrawal without completely depleting the portfolio by life expectancy) are enhanced by selecting the Roth conversion:

Summary:

As this case study demonstrates, the factors outlined herein clearly favor a Roth conversion, even though the future effective tax rates are assumed to be significantly lower than the current tax rate in this case.