The 4 Effects of a Roth Conversion

We’ve talked quite a bit about Roth conversions over the years. (For instance, see: Roth Conversion Rules FAQ, Roth Conversion Planning: A Step-By-Step Approach, and Roth Conversion Analysis: Not Breakeven Analysis.) Yet they are still one of the topics that comes up most frequently in questions from readers.

So what follows are the four primary things I think about when evaluating a potential Roth conversion — the four primary ways in which a Roth conversion can change a household’s trajectory.

Effect #1: Pay Tax Now Instead of Later

The first effect of a Roth conversion is that you pay tax now (on the conversion) instead of later (i.e., whenever the money would come out of the account later, if you don’t convert it right now). This is the effect that gets the most discussion because it’s the most obvious one and because it is the only effect of the four that is always applicable.

This first effect can be helpful or harmful. It’s helpful if the tax rate you pay on the conversion is lower than the tax rate that would have been paid later. And it’s harmful if the tax rate paid on the conversion is higher than the tax rate that would have been paid later.

With regard to this first effect, there are two important subtleties to keep in mind:

• The “pay tax later” tax rate might be the tax rate you would pay later on distributions for spending or RMDs. But it might also, to an extent, be the tax rate that your heir(s) would pay later on distributions from inherited tax-deferred accounts. Or, it can even be a 0% tax rate, to the extent the money goes to charity — either via qualified charitable distributions (QCDs) or as a bequest.
• When doing this analysis, you must look at actual marginal tax rates (ideally including Medicare IRMAA effects) rather than just tax brackets. As we’ve discussed in various previous articles, there are many things that can cause your marginal tax rate to be different than just your tax bracket.

Effect #2: Using Taxable Dollars to “Buy More” Roth Dollars

The second effect of a Roth conversion occurs when you get to use taxable dollars (i.e., non-retirement-account dollars) to pay the tax on the conversion. If applicable, this effect generally is beneficial, though how beneficial it is varies from one household to another. Some relevant factors would include:

•  The length of time that the money will stay in the Roth. (That is, how long do you get to benefit from the tax-free growth that the dollars will now experience, because they’re no longer in a taxable account?) This could be “time until you spend the dollars.” Or it could be “time until the dollars have to come out of the account as distributions to heirs” (in which case your age and health would be major factors).
• What rate of return you anticipate earning on the assets and how that return is broken down in terms of interest/dividends/price appreciation.
• The tax rate(s) you would have to pay on that return (and when you would have to pay it), if the assets stayed in a taxable account.
• What (if any) tax cost must be incurred as a result of selling the taxable assets in question now in order to use that money to pay the tax on the conversion.

Of course, if you don’t have significant assets in taxable accounts (and you would therefore be using dollars from the traditional IRA to pay the tax on the conversion), this effect is not applicable.

Effect #3: Smaller RMDs (Less Future Tax Drag)

The third effect of a Roth conversion is that it reduces your later RMDs (because Roth IRAs don’t have RMDs during the original owner’s lifetime), thereby reducing future tax drag if you aren’t spending (or donating) your RMD dollars.

To be clear, we’re not talking here about the tax paid on the RMDs themselves. That would fall under effect #1. What we’re talking about here is that, after an RMD is taken, if the money is just reinvested in a taxable brokerage account, it will incur taxes on any further growth. (And, critically, that tax would not occur if a conversion were done, because the dollars would be in a Roth IRA.)

This effect of a conversion can never be harmful. Though, as with effect #2, it might not apply. RMDs are (in a several way tie for) the most tax-efficient dollars to spend every year. If you’re going to spend (or QCD) your entire RMD every year, this effect is a zero because the dollars aren’t getting reinvested in a taxable account.

Other relevant factors that influence the size of effect #3 include:

• The length of time that the money would be in a taxable brokerage account (rather than a Roth IRA) after taking the RMD. Of note, unlike with effect #2 above, your current age is not a factor here unless you’re already age 72, because this effect by definition does not begin until age 72. Your health is a major factor though.
• What rate of return you anticipate earning on the assets and how that return is broken down in terms of interest/dividends/price appreciation.
• The tax rate(s) you would have to pay on that return (and when you would have to pay it), if the assets stayed in a taxable account.

Effect #4: Fewer Dollars Appearing on the Balance Sheet

The fourth effect of a Roth conversion is that you now have fewer total dollars. For example, there might now be $75,000 in a Roth IRA whereas before there was $100,000 in a traditional IRA.

For most people, this doesn’t matter at all. But it is helpful for anybody whose estate will be subject to an estate tax. (Given the current federal estate tax exclusion amount, few people have to worry about federal estate tax. But 12 states, as well as Washington DC, have estate taxes, many of which kick in at significantly lower thresholds.)

So like effects #2 and #3, this effect will be irrelevant for many households, whereas it will be helpful for others. (I’m not aware of any ways in which it would be harmful.)