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When Does a Roth Conversion Make Sense?

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).

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