Is a Roth Conversion a Good Idea?

A reader writes in, asking:

“Regarding Roth conversions, is it worth it to convert, putting yourself in pretty high tax brackets if you have a lot to convert? Second is it worthwhile to do some converting when the result would likely still leave you with heavy RMD’s and 85% of SS taxed, nullifying some of the better reasons to convert?”

In the simplest situation — in which a person has only tax-deferred and Roth accounts — it usually only makes sense to do a Roth conversion if your marginal tax rate on the conversion is lower than you expect your marginal tax rate to be at every point in the future. (Otherwise, you could wait until the point at which you do have the lower tax rate and do the conversion then.)

Even with this simple situation, however, there are three additional points to keep in mind.

First, at least in theory, this analysis should be done dollar-by-dollar, because converting isn’t an all-or-nothing question. For example, if you have $500,000 in a traditional IRA, it may make sense to convert some of it. But after you’ve already converted a certain amount this year, you reach a point where your marginal tax rate on additional conversions is higher (e.g., because you’re in a higher tax bracket or because you reach a point where additional income would reduce/eliminate your eligibility for a certain tax break), so the math changes for additional conversions.

Second, you must include any applicable penalty when figuring the marginal tax rate on the conversion. For example, if you have $100,000 in a traditional IRA and you move $85,000 to a Roth IRA and $15,000 to your checking account in order to use it to pay the tax on the conversion, that $15,000 would count as a distribution and could be subject to the 10% penalty if you’re under age 59.5.

Third, as we’ve discussed here on several occasions, your marginal tax rate is not necessarily the same as your tax bracket. (It’s super common, for instance, for retirees to have a higher marginal tax rate than the tax bracket they’re in, due to the way in which Social Security is taxed.)

What if You Have Taxable Accounts As Well?

With taxable accounts in the mix as well, the analysis becomes much more complicated. In short, having money in taxable accounts typically makes Roth conversions more appealing, because you can use that taxable account money to pay the tax on the conversion, rather than having to siphon off some of the IRA assets to pay the tax.

As a result, if you have non-retirement-account assets with which you could pay the tax, Roth conversions typically make sense even if you expect to have only the same marginal tax rate in the future as you have right now. In fact, they can even make sense in some cases in which you currently have a higher marginal tax rate than you expect to have in the future — because the advantage that comes from tax-sheltering more of your assets may outweigh the disadvantage of paying a (relatively) high tax rate on the conversion.

In cases in which your tax rate on the conversion would be higher than the marginal tax rate you expect to face in the future, some of the factors to consider when deciding whether to convert or not would include:

• How much higher is your current marginal tax rate than the marginal tax rate you expect to face in the future? (The greater the difference, the more appealing it becomes to wait rather than do a conversion now.)
• How long do you expect the assets be in the Roth account? That is, how long before you expect to spend the money? (The longer, the greater the savings from a conversion due to not having to pay tax on further growth.)
• What rate of return would you expect for the assets in question? (The higher, the greater the savings from a conversion.)
• Do you have sufficient cash on hand in taxable accounts to pay the tax (or, alternatively, assets in taxable accounts that have cost basis equal to or greater than their current market value)? If you would have to liquidate taxable holdings — and pay capital gains taxes in doing so — in order to raise cash to pay the tax on the conversion, that’s a point against the conversion.
• How likely do you think it is that you’ll be leaving these assets to heirs? (In many cases, it’s actually tax-efficient to leave taxable assets to heirs, because the heirs would get a step-up in cost basis.)

As you can see, this isn’t a question to which you can calculate a definitive answer, because many of the factors are unknowable. As a result, you may find that it makes sense to take a middle-of-the-road sort of approach, in which you do relatively modest conversions each year (perhaps converting until you reach the top of your current tax bracket) and sometimes converting more in years in which your income (and therefore marginal tax rate) is lower or the market is down (thereby reducing the cost of a conversion).