“Roth Conversions to the Top of the 12% Bracket” is Not a Great Rule of Thumb

A rule of thumb that’s becoming increasingly popular is to do Roth conversions in retirement to the top of the 12% bracket and no higher.

Any rule of thumb is going to have some situations in which it doesn’t work well, but I think this rule of thumb is particularly bad.

Firstly, there are some households for which any conversions are likely to be unhelpful, due to their charitable plans (i.e., they plan to make extensive use of qualified charitable distributions, and they have charities named as the beneficiaries of their tax-deferred accounts). When that’s the case, any current conversions are largely money down the drain. Much of the dollars in question would face a 0% tax rate later, so why pay even a 12% tax rate right now?

And on the other side, there are a variety of factors that would make conversions beyond 12% likely to be beneficial (e.g., super large tax-deferred accounts, such that we’re likely to see a high tax rate on RMDs, or beneficiaries with very high income levels of their own, such that they’d likely pay very high tax rates on inherited tax-deferred accounts).

But the most fatal flaw with the rule of thumb in question is that, for many retiree households, the “up to the top of the 12% bracket” range often includes stuff that will make the tax rate paid on the conversion meaningfully higher than 12%. The most common such things are the unique tax treatment of Social Security benefits (i.e., each dollar of conversion income also causes some Social Security benefits to become taxable) and the phaseout of Affordable Care Act subsidies (i.e., conversion income is causing the premium tax credit to shrink/disappear and potentially causing the loss of cost sharing reductions).

For many retirees (in particular, households where somebody is buying insurance on the exchange or somebody is already receiving Social Security), their marginal tax rate in much of the 12% bracket actually exceeds 20%. And if that’s advantageous, then conversions into the 22% bracket are often likely a good idea as well (because in many cases, much of the 22% bracket doesn’t have those additional tax rate effects).