Roth Conversion Analysis: Break-Even Tax Rate

Last year Vanguard released the following paper and accompanying calculator:

• A ‘BETR’ [Break-Even Tax Rate] Approach to Roth Conversions by James Passman, Boris Wong, and Joel Dickson
• Roth Conversion Break-even Tax Rate Calculator

The paper is excellent. The gist of the paper is essentially:

• People often think of the Roth conversion decision as a comparison of the tax rate they’d pay on the conversion, as compared to the future tax rate that would be paid on those dollars later.
• But there’s more to the analysis than that, because Roth conversions also have other effects, such as the beneficial effects of using taxable-account dollars (rather than dollars from the IRA) to pay the tax on the conversion.
• And when you account for those other factors, it reduces the “future tax rate” that would be necessary in order for a conversion to ultimately be advantageous. That is, a conversion might actually be advantageous even if the “future tax rate” is actually somewhat lower than the tax rate you end up paying on the conversion.

That’s absolutely true. I agree with all of the above. (You can find me saying similar things in The 4 Effects of a Roth Conversion or in my Roth Conversion Deep Dive presentation from the 2024 Bogleheads Conference.)

The calculator is essentially an implementation of the examples the authors provide in the paper. I think the calculator is interesting — worth experimenting with — but frankly I don’t think this is the best way to do a Roth conversion analysis. Rather, I think it’s preferable to look at Roth conversions as part of a much broader analysis, modeling projected cash flows through retirement.

For example, in Figure 2 in the paper (or using the calculator with the same set of assumptions), they show a very low break-even tax rate if the tax on the conversion is paid with cash. But a critical assumption being made here is that, in the no-conversion scenario, the calculator is assuming that the cash sits there for the duration of the 20-year calculation.

More comprehensive planning software would be able to calculate whether (based on the household’s other projected cashflows), that cash is likely to be spent elsewhere in the near future. In other words, if we spend the cash on the conversion tax, but now (because we no longer have that cash available) we have to liquidate a bunch of appreciated taxable account assets to pay the bills for the next 12 months, it’s essentially as if we liquidated those appreciated taxable assets, rather than the cash, to do the conversion.

And, when considering liquidating taxable assets to pay the tax on the conversion, the calculator assumes that there’s no capital gain tax to pay. In real life, of course we have to bring that into the analysis as well. (In some cases, for instance, if the taxable assets are highly appreciated, it might be better to aim to preserve them for heirs who would receive a step-up in cost basis.)

To be clear, I don’t think that the above constitute flaws with the paper. The paper is excellent in raising important ways in which the analysis is affected by more than just the “current and future tax rate.” And the assumptions the authors use are reasonable for the examples given. But actually doing the analysis in exactly the way they discuss (or using the calculator that does exactly that) is in my opinion not as helpful as more comprehensive planning software that is going to account for much more.

Among people who read personal finance books, many save a high percentage of their income through most of their careers. One thing that eventually happens for some such people is that they reach a point at which they realize they have not only saved "enough," they have saved "more than enough." Their desired standard of living in retirement is well secured, and it’s likely that a major part of the portfolio is eventually going to be left to loved ones and/or charity. And that realization raises a whole list of new questions and concerns.

This book’s goal is to help you answer those questions.