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Roth Conversion Rules FAQ

After the recent article “Roth Conversion Planning, a Step-by-Step Approach,” it has become clear through emails from readers that lots of people have questions — not just about the decision making process, but about the rules themselves. So what follows is a brief FAQ about the rules surrounding Roth conversions.

Is there an income limit for Roth conversions?

No. There used to be a limit. (Prior to 2010, you could not do a Roth conversion if your modified adjusted gross income exceeded $100,000.) But there is no longer an income limit.

Is there an income requirement for a Roth conversion?

No. While you (or your spouse) must have earned income in order to make a Roth IRA contribution, you do not have to have any earned income in order to do a Roth conversion.

Is there a maximum amount you can convert per year?

No. There is no maximum conversion — other than the fact that you can’t convert more than you have in tax-deferred accounts.

Can you do a partial conversion, or do you have to convert the whole account at once?

You can do a partial conversion of a traditional IRA. For example, converting $20,000 of a $100,000 account is perfectly allowed.

And in most cases in which conversions make sense, doing partial conversions over a period of years is in fact what’s most desirable — converting only enough to put your income up to a particular threshold each year, rather then converting the whole account at once. Converting the whole account at once would often mean paying a high tax rate on the conversion, as it would mean having a very high level of income that year. (Of course, this depends on the size of the account.)

Note that the same is true for a 401(k). If your 401(k) allows for in-plan conversions, you can do a partial conversion to Roth 401(k).

How is a Roth conversion (from a traditional IRA) taxed?

Generally, a Roth conversion will be taxable as ordinary income.

If, however, you have made nondeductible contributions, a portion of the conversion will not be taxable. Specifically, the percentage of the conversion that is not taxable is calculated as:

  • Your basis in traditional IRAs, divided by
  • The sum of your traditional IRA balances on 12/31 of the year of the conversion and any distributions and conversions from traditional IRAs that occurred that year.

Your basis in traditional IRAs is the sum of your nondeductible contributions, minus any portions of those amounts that have been distributed or converted.

For example, if you have made $20,000 of nondeductible contributions over the years (and none of those amounts have been distributed or converted), you have $20,000 of basis in your traditional IRAs. If you do a $100,000 conversion, and at the end of the year your traditional IRAs are in total worth $400,000, then 4% of your $100,000 conversion would be nontaxable.

That is, $20,000 (basis in traditional IRAs) divided by $500,000 (i.e., the sum of the conversions/distributions for the year and the sum of your traditional IRA balances at the end of the year) equals 4%. So you would have $96,000 of gross income as a result of the $100,000 conversion.

Something that surprises many people is that if, for example, you do a Roth conversion in March and then in November of the same year you roll a 401(k) into a traditional IRA, that rollover is going to affect the portion of the conversion that’s taxable (because it will increase your traditional IRA balance on 12/31 of that year).

Another key point here is that all of your traditional IRAs (including SEP and SIMPLE IRAs) are considered to be a single IRA for the purpose of this calculation. (See: “When are IRAs Aggregated?”)

How is an in-plan Roth conversion (e.g., a conversion within a 401(k)) taxed?

As with a conversion of a traditional IRA, the conversion will generally be taxable. Also similarly, if you have made nondeductible, non-Roth (i.e., “after-tax”) contributions to the plan, a portion of the conversion will be nontaxable. And again, it’s a pro-rata calculation.

However for this calculation, unlike with IRAs, the 401(k) is not aggregated with other 401(k) plans.

Also, if the plan separately accounts for the after-tax contributions and their earnings, then it’s possible to largely avoid the pro-rata rule, because you can have just those amounts (i.e., the after-tax contributions and their earnings) converted. In such a case you would only have to pay tax on the earnings on the after-tax contributions.

Can a Roth conversion trigger the 10% penalty?

If you are under age 59.5, any money that comes out of the traditional IRA and does not end up going into the Roth IRA may be subject to the 10% penalty. For instance, if you take $100,000 out of your traditional IRA, $75,000 goes into your Roth IRA, and $25,000 is withheld to pay the tax on the conversion/distribution, the $25,000 would be subject to the 10% penalty if you’re under age 59.5 and don’t meet one of the other exceptions to the penalty.

When is a Roth conversion taxed?

A Roth conversion is taxable in the year in which it occurs. That is, conversions work on a calendar-year basis. There’s no “I’m doing this in March of 2022, and I want it to count for 2021” option as there is for contributions to an IRA.

How are distributions from a Roth IRA treated, after a conversion?

When amounts that were converted to a Roth IRA are distributed from the Roth IRA, they will not be subject to ordinary income tax. They might be subject to a 10% penalty. But that penalty will not apply if you’re at least age 59.5, or if the conversion was at least 5 years ago, if the conversion itself wasn’t taxable, or if one of several other exceptions applies. For more details, see “Roth IRA Distribution Rules” or the Roth IRA Distribution Tool.

Can I do a Roth conversion of an inherited IRA?

No — unless you inherited it from your spouse, in which case you’re allowed to treat the account as your own, which allows you to do a conversion into your own Roth IRA.

Can I recharacterize (undo) a Roth conversion?

No. As a result of a change made by the Tax Cuts and Jobs Act of 2017, you can no longer recharacterize a Roth conversion.

Does a Roth conversion satisfy my RMD for the year?

No. If you have to take a required minimum distribution (RMD) in a given year, a Roth conversion does not count toward that RMD.

August 30, 2021

Investing Blog Roundup: Guaranteed Income as a “License to Spend”

This week I encountered a recent paper by David Blanchett and Michael Finke in which they found that, among retiree households with similar levels of wealth, the greater the percentage of that wealth that is held in the form of guaranteed income (i.e., Social Security, pension, or annuity income), the more the household spends.

To an extent, this makes perfect sense, as a household whose wealth is overwhelmingly in the form of stocks and bonds must pick a conservative spending rate to protect against the possibility of poor investment returns, a very long retirement, or a combination of the two, while a household with a high level of pension (or similar) income can generally feel pretty safe spending all of that income. Blanchett and Finke found though that the size of the difference indicates that retirees with a low percentage of guaranteed income are likely being even more conservative than they need to be, in terms of spending rate.

Recommended Reading

Thanks for reading!

August 20, 2021

How Much Cash Should a Retirement Savings Portfolio Include?

A reader writes in, asking:

“What do you think is an appropriate level of cash allocation in a portfolio for retirement savings?”

Let me begin with my standard disclaimer for any asset allocation question: there’s a broad range of what is reasonable. There is no one perfect allocation, and it’s a waste of time to try to find such.

For any particular investor, there’s an approximate overall level of risk that is appropriate, and there are countless different ways to get to that level of risk. So, for example, if you like to use cash instead of bonds because doing so allows you to feel comfortable with a slightly higher stock allocation, that’s perfectly reasonable.

But, in most cases, a retirement portfolio will not require a cash allocation at all.

As for our household (still in the accumulation stage), our retirement portfolio has no intentional cash allocation. It’s all stocks or bonds. (More specifically, it’s 100% Vanguard LifeStrategy Growth Fund and has been for ~10 years.)

That said, we do keep a few months of expenses in checking accounts. In part, that’s because my own income has a high degree of variation from one month to the next. That’s just the nature of self-employment. If we were both paid a predictable monthly salary, we would probably keep a smaller amount in checking accounts.

Similarly, if we were retired and our Social Security/pension/annuity income were sufficient to pay the bills, I’d be comfortable with a very small amount in checking. Assets from investment accounts can be tapped pretty quickly. Even for an unexpected large expense, you can use a credit card to pay the expense, then liquidate some assets from investment accounts to be able to pay off the credit card promptly (i.e., before paying any interest).

As far as cash as an asset class, it does what you would expect it to do: it reduces the overall volatility of the portfolio, but it earns almost no return, even before inflation.

Some people hope to use cash holdings to actually improve returns by deploying it at opportune times, but that’s harder than it might appear. For instance, by January of 2009, the market had spent the last several months moving dramatically downward. So it was clearly a better time to buy than it was several months ago. But was this the bottom? Or would it be better to continue to wait? (If you wait, it might turn out that this was the bottom, and you end up having to buy at a higher price.)

I certainly had no idea at the time. I never have any idea where the market is heading next, so I have no interest in holding cash just to hope to take advantage of such opportunities.

And for all of the years in which the stock market doesn’t provide any crash-fueled, obvious buying opportunity, the money that you have sitting in cash is just missing out on returns.

For instance, over the last 10 years, Vanguard Short-Term Treasury Index Fund (which we can use as a stand-in for cash) went up in value by about 12%. By contrast,

  • Vanguard Total Bond Market Index Fund has increased in value by about 39%, and
  • Vanguard Intermediate-Term Treasury Index Fund increased in value by about 30%.

Depending on which comparison fund we’re looking at, that’s a cumulative 18-27% return shortfall by having the money sit in cash. That’s not massive, but it’s not nothing. And it’s not as if a total bond fund or intermediate-term Treasury fund is any sort of terrifying roller coaster ride.

So, again, cash is a perfectly reasonable thing to include in almost any asset allocation, because it’s one tool that you can use to adjust the portfolio’s overall risk level to where you want it. But it’s uncommon for a portfolio to need any cash allocation at all.

There is one specific case in which I do think cash can play a critical role. If you’re retired and you’re temporarily spending from your portfolio at a high rate until Social Security (or a pension) kicks in, it’s important to use something very safe like cash or CDs for satisfying that extra-high level of spending, because, for that money, you can’t afford to take on much risk at all.

August 16, 2021

Investing Blog Roundup: Roth IRA Distribution Tool

After recently writing about Roth IRA distribution rules, I was asked to create a tool, so you can just answer a few questions and get the answer as to how your distributions will be treated. So, here it is:

It’s nothing fancy — just a basic tool that guides you to the applicable outcome from the rules we discussed recently.

Recommended Reading

Thanks for reading!

August 6, 2021

Prepay the Mortgage or Buy I-Bonds?

A reader writes in, asking:

“I have been making sure to make my mortgage a priority the last few months because I realized that is the highest paying fixed income investment I could invest in at the moment because I understand how to compare it to the yield on typical bonds. But when I compare to I bonds, how do I perform this comparison? For example, on the I bonds issued between May and November of this year…is it better to pay my 3.125% mortgage or invest in these I bond issues with composite rate 3.54%, fixed 0%?”

Comparing Risk

As a bit of background information for readers not familiar with I Bonds, their interest rate is made up of two components: a fixed rate and a variable rate.

The fixed rate stays the same through the life of the bond. For I Bonds purchased right now, the fixed rate is 0%.

The second component is a a variable rate that gets recalculated every 6 months, based on the rate of inflation over the prior 6 months (specifically, the change in the Consumer Price Index for all Urban Consumers). For I Bonds purchased right now, the variable rate is 3.54%.

So, today, when we see a 3.54% composite rate, made up of a 0% fixed rate and 3.54% variable rate, we only know that that variable rate will be applicable for 6 months. After that, it could be lower or higher, depending on inflation.

In contrast, if the mortgage is a regular fixed-rate mortgage, we know what the rate of return will be (i.e., the after-tax rate of interest that you no longer have to pay).

Of course, that’s in nominal terms. In real (i.e., inflation-adjusted) terms, it’s the I Bonds that have the predictable rate of return (in this case, 0%, minus any tax you would have to pay on the variable rate), whereas the mortgage has an unpredictable rate of return (i.e., the rate on the mortgage, tax-adjusted, minus whatever inflation turns out to be).*

Comparing Returns

In both cases, we want to look at the after-tax rate of return.

If your mortgage interest is fully deductible, we would multiply the interest rate by 1 minus your marginal tax rate (federal + state, if you can deduct the interest at the state level as well). For example with a 30% marginal tax rate, paying down a 3.125% mortgage would provide a nominal after-tax rate of return of 2.1875% (i.e., 3.125% x 0.7).

And you would also want to adjust the interest rate on the I Bonds accordingly. I Bonds are generally taxable at the federal level. But they are exempt from state income tax. In addition, if the bonds are ultimately used to pay higher education expenses, the interest will be federally tax free as well.**

In short, there’s going to be a break-even rate of inflation at which you are indifferent to prepaying the mortgage as opposed to buying I Bonds.

If taxes were not a consideration, that would be 3.125%. (That is, if inflation is 3.125% over the period in question, both I Bonds with a 0% fixed rate and prepaying a 3.125% mortgage would have a 3.125% nominal return or a 0% real rate of return.)

Considering taxes, we’d want to do some algebra in which we set the real rate of return on the mortgage equal to the real rate of return on the I bonds, and solve for inflation.

That is:

  • mortgage real rate of return = I Bonds real rate of return

The mortgage real rate of return can be written as:

  • after-tax mortgage interest rate − inflation.

And the real return for the I Bonds can be written as:

  • fixed rate − taxes paid on fixed rate + variable rate − taxes paid on variable rate − inflation

For I Bonds purchased today, the fixed rate is 0%. And the variable rate will always be equal to inflation. So we can rewrite the real rate of return for I bonds purchased today as:

  • 0 − 0 + inflation − (inflation * marginal tax rate) − inflation

Or simply:

  • − (inflation * marginal tax rate)

For example, if the mortgage has a rate of 3.125% and you expect a 30% tax rate on the mortgage and a 22% tax rate on the I Bonds, the break-even rate of inflation would be 2.804%.

  • mortgage real rate of return = I Bonds real rate of return
  • 3.125% * 0.7 − inflation = −0.22 * inflation
  • 2.1875% − inflation = −0.22 * inflation
  • 2.1875% = 0.78 * inflation
  • inflation = 2.804%

That is, with inflation of 2.804% and a 30% tax rate on the mortgage and 22% tax rate on the I Bonds, they each provide the same after-inflation, after-tax rate of return.

Mortgage real rate of return = 3.125% * (1 − 0.3) − 2.804% = −0.617%

I Bonds real rate of return = −0.22 * 2.804% = −0.617%

If you expected inflation greater than 2.8%, I Bonds would be expected to provide a greater after-tax return. If you expected inflation less than 2.8%, the mortgage would be expected to provide a greater after-tax return.

Liquidity

Another important difference between using cash to buy I Bonds and using cash to pay down a mortgage is that buying I Bonds would preserve a greater degree of liquidity. You can cash I Bonds after one year. (If you cash them before five years, you lose the previous three months of interest.) Whereas when you pay down a mortgage, that cash is gone, and there is no cashflow benefit until the mortgage is paid off.

*Throughout this article I am using the simplifying convention of subtracting inflation from the nominal return in order to find the real return. The more precise math is to divide (1 + nominal return) by (1 + inflation), then subtract 1.

**For simplicity’s sake, I am ignoring the fact that with I Bonds you have the choice to pay tax on the interest each year or defer taxation until the year in which you cash the bond or the bond matures. In theory, deferral is an advantage. But the specifics will depend on how your marginal tax rate changes over time.

August 2, 2021
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