Oblivious Investor

After the recent article about maximizing after-tax dollars (as opposed to minimizing taxes), several people wrote in to ask about Roth conversions — specifically, when does it make sense to do one?

The answer depends significantly on how you are going to pay the tax on the conversion: would you be using money from the traditional IRA, or would you be using money from a taxable account? For example, compare the two following scenarios, each of which involves a conversion at a 20% anticipated marginal tax rate.

Example #1: Charlie takes $50,000 out of his traditional IRA and moves $40,000 of it to a Roth IRA. The remaining $10,000 will be used to pay the tax on the conversion.

Example #2: Kiara takes $50,000 out of her traditional IRA and moves all $50,000 of it to a Roth IRA. She will use $10,000 from her regular checking account to pay the tax on the conversion.

Using Retirement Account Dollars to Pay the Tax

For cases in which dollars from the traditional IRA would be used to pay the tax on the conversion, it’s purely a question of marginal tax rate.* That is, each year, for each dollar in the traditional IRA, you would ask what your current marginal tax rate would be if you converted that dollar right now, and you compare that to what the marginal tax rate would be for that dollar if you did not convert (i.e., what tax rate would be paid whenever the money comes out of the account later).

If the current marginal tax rate is lower, then a conversion is advantageous. If the current marginal tax rate is higher, then a conversion would be disadvantageous.

To back up a step, a traditional IRAs can be roughly thought of as a Roth IRA, of which the government owns a portion. For example, if you expect a 25% marginal tax rate in retirement, a traditional IRA is much like a Roth IRA, of which you own 75% and the government owns 25%.

When you do a Roth conversion, you’re essentially “buying out” the government’s share of the converted dollars. If your current marginal tax rate is lower than the marginal tax rate you expect later on (i.e., whenever you would be distributing the dollars in question), then you’re buying out the government’s share at a bargain price (e.g., paying 15% now when you would otherwise be paying 25% later). If your current marginal tax rate is higher than the marginal tax rate you expect later on, then you’re buying out the government’s share at a high price (e.g., paying 30% now when you could instead pay 25% later).

Using Taxable Dollars to Pay the Tax

If, however, dollars from taxable accounts (e.g., just a regular checking or savings account) would be used to pay the tax on the conversion, then the analysis changes somewhat. You’re using non-retirement-account dollars to buy the government’s share of your IRA. And that, in itself, provides some value.

The key point here is that taxable accounts grow at a slower rate than IRAs, because you have to pay tax on interest/dividends each year. So now there are two things going on with the conversion:

1. As in the prior case, you’re buying the government’s share of the IRA now, rather than later (i.e., paying at your marginal tax rate now rather than your future marginal tax rate), which could be advantageous or disadvantageous, and
2. You are using taxable account dollars to buy IRA dollars, which is advantageous.

In the analysis, marginal tax rates are still super important (because of point #1).

But now we’re also concerned with time frame and rates of return (because of point #2). Again, dollars in an IRA grow at a faster rate than dollars in a taxable account, because you don’t have to pay tax each year on the interest/dividends. The greater the length of time that these dollars will remain in the IRA, the more impactful that fact becomes. That is, the money will be compounding at a faster rate in the IRA, but if that’s only happening for a few years, that’s not so important. If it will be happening for a few decades, it’s super important. And expected rate of return matters as well. If the expected rate of return (before considering taxes) isn’t that high to begin with, then the tax cost within a taxable account isn’t so great. Conversely if the expected rate of return is very high, then the cost of having the money in a taxable account becomes much more significant.

The result of all of this is that, if you’re using taxable dollars to pay the tax, then, depending on time frame and expected rate of return, it might even be advantageous to do a Roth conversion if the current marginal tax rate is higher than you would expect it to be in the future.

*I know I harp on this over and over, but it’s critical to understand that your marginal tax rate is not necessarily the same thing as your tax bracket. In many cases, especially in retirement, your marginal tax rate will be greater than your tax bracket because additional income not only causes the normal amount of income tax, it also causes something else undesirable to happen (e.g., it causes a particular credit to phase out, it causes more of your Social Security to become taxable, or it causes your Medicare premiums to increase).

When done properly, the goal of tax planning is not to minimize your taxes. Instead, the goal is to maximize the money that is left after taxes.

That may sound like a trivial distinction — like I’m just playing games with words here. But it makes a real difference in the analysis.

Let’s look at two common examples, starting with the more obvious one.

Mortgage Interest

You have a $300,000 mortgage with a 3% interest rate. You itemize your deductions every year, and you are able to fully deduct the interest you pay on your mortgage. You have a 25% marginal tax rate, when both federal and state income taxes are considered.

You have $50,000 in a checking account, which you don’t really need for “emergency fund” purposes. Let’s imagine that it’s from a CD that just matured.

If you use that $50,000 to pay down your mortgage, you’ll be saving yourself $1,500 of interest per year. You will lose a $1,500 deduction, which means that your taxes will go up by $375, given a 25% tax rate. But your overall financial position is still improved by $1,125 per year.

Your taxes went up, but that’s fine. The goal is not to minimize taxes, but rather to maximize the amount of money left after taxes. Prepaying your mortgage achieves that goal, in this case.

Let’s move to our second, less obvious example.

Roth vs Tax-Deferred

Looking at your budget for this year, you determine that you have sufficient cash flow to make $7,500 of Roth contributions to your 401(k) this year. Alternatively, you could make tax-deferred (“traditional”) contributions. You currently have a 25% marginal tax rate, and you expect to have a 15% marginal tax rate in retirement. You also expect that, given the length of time in question, this money will approximately triple in value between now and the time you take it out of the account.

If you make Roth contributions, there is no effect on your income tax this year (because the contribution is not deductible), and when you take the money out in retirement, it will be completely tax-free.

Alternatively, if you have $7,500 of available cash flow this year, you could contribute $10,000 to a tax-deferred 401(k), given a 25% marginal tax rate. (That is, if you make tax-deferred contributions of $10,000, you’ll have tax savings this year of $2,500, so your cash flow this year will only be affected to the tune of $7,500, which is the amount we have decided you can afford.)

If you make tax-deferred contributions, when you take the money out (by which point the $10,000 will have tripled in value to $30,000), you will have to pay a total tax of $4,500, given your anticipated 15% marginal tax rate in retirement.

So, in our example, with tax-deferred contributions, you end up paying more tax in total. You get $2,500 of savings up-front, but you pay $4,500 of additional tax later. If you do the analysis with the goal of minimizing taxes, you would make Roth contributions.

But which option actually leaves you with more after-tax money?

In the Roth case, you contribute $7,500, and that money triples to $22,500. And $22,500 is already the after-tax value, because it can come out of the account tax-free.

In the tax-deferred case, you contribute $10,000, and that money triples to $30,000. But then you have to pay $4,500 of taxes. Still, your after-tax value is $25,500 (i.e., $3,000 more spendable dollars than you would have if you had made Roth contributions).

Overall point being, when you contribute to Roth accounts rather than tax-deferred accounts, you generally pay a smaller dollar amount of income tax (because you’re paying tax now, on the amount of the contribution, rather than on the larger amount of the distribution after it has grown over time), but that doesn’t necessarily make it better. Because the goal isn’t to minimize taxes. The goal is to maximize the after-tax dollars that you have available to you.

Focus on After-Tax Dollars

This topic comes up with so many of the common tax planning questions. Which account(s) should I spend from this year? Which assets should I hold in which accounts (i.e., asset location)? Should I spend down my traditional IRA in order to delay Social Security? Should I make a donation from my taxable assets, or via a qualified charitable distribution?

In each case, calculating the taxes paid under Option A and calculating the taxes paid under Option B — then comparing those two amounts — is such an obvious, intuitive way to do the analysis. And in each case, that method can lead you to poor decisions.