Use Cash for a Roth IRA Contribution or Roth Conversion?

A reader writes in, asking:

“I recently rolled over the balance (all in stocks) from my previous employer’s 403(b) into a rollover IRA. With the downdraft in the stock market, I am considering doing a Roth conversion with that balance, which would result in about a $7,000 tax liability. I have yet to contribute up to $7,000 to my Roth IRA for 2022. I would have funds for doing either one or the other this year. At first glance, there appears to be no advantage of doing one over the other choice (recognizing I have until the end of 2022 to do a conversion, 4/15/23 to do a contribution)… but I’m not so sure. Am I missing some angle that would help me lean one way or another?”

Let’s run through an example to illustrate the differences. If we assume, for example, a 25% combined federal/state marginal tax rate on the conversion, that would mean choosing between a conversion of $28,000 or a $7,000 Roth IRA contribution.

Option A: convert $28,000

Result:

• You have taken $28,000 out of tax-deferred.
• You have added $28,000 to Roth.
• You have taken $7,000 out of taxable (i.e., $7,000 spent from checking to pay the tax).
• As you noted, you still have the option (later) for a contribution for this year.

Option B: no conversion, contribute $7,000 to Roth IRA.

Result:

• You have not changed the amount in tax-deferred.
• You have added $7,000 to Roth.
• You have taken $7,000 out of taxable (i.e., $7,000 moved from checking to Roth IRA as the contribution).

In other words, aside from Option A preserving the option to contribute to a Roth IRA for this year, the primary difference (in this scenario assuming a current 25% marginal tax rate) is that Option A leaves you with $21,000 more in a Roth IRA, whereas Option B leaves you with $28,000 more in tax-deferred. So of course a critical question is: would you rather have $21,000 in Roth, or $28,000 in tax-deferred?

And the primary factor in that decision would be: what tax rate would you expect to be paid on these tax-deferred dollars later (i.e., whenever they come out of the account later, if you don’t convert them now)? That tax rate might be your tax rate on RMDs in retirement. It might be a later tax rate at which you could convert them (e.g., after retiring but before Social Security and RMDs begin). It might be your heirs’ future tax rates. Or it might be 0%, if you would anticipate a high likelihood of these dollars ultimately going to charity as a qualified charitable distribution or as a bequest.

If that projected future tax rate is 25% or more, having $21,000 in a Roth IRA would be preferable to having $28,000 in a traditional IRA (i.e., the Roth conversion would be the better way to use the $7,000 of cash).