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Roth Conversions - When Is Enough Enough?

It takes more than simple rules of thumb that focus on marginal income tax rates to decide whether a Roth conversion makes sense or not. Dana Anspach of Sensible Money describes three ways to evaluate whether a Roth conversion adds value to your financial plan or not.

Roth conversions are a hot topic, but can there be too much of a good thing?

Maybe so, says Dana Anspach, CFP®, RMA®, founder and president of Sensible Money.

“I'm a big fan of Roth conversions, but lately we've received some inquiries from people who want to convert everything to a Roth,” she said in an interview. “They have a lot of tax-deferred assets and they've read about Roth conversions, and they are almost taking it to an extreme. So, yes. I think there can be too much of a good thing. You have to be careful not just to assume because they are so fabulous, you should put all your money in them.”

How might you know whether to do a Roth conversion and how much to convert?

According to Anspach, there are at least two rules of thumb that people often use.

Higher or lower marginal tax rate. Simplistic guidelines, for instance, tell you to look at tax rates. If your marginal tax rate will be the same or lower in retirement, don’t convert. But if your tax rate will be higher, convert.

Zero taxes in retirement. Other proponents of Roth conversions recommend converting everything with the goal of getting to zero taxes in retirement. For instance, a client recently asked Anspach about a strategy they heard about where you convert enough that when your required minimum distributions begin, your expected distribution would be about equal to your standard deduction. Thus, all the income from your IRA distribution would be offset by your deduction.

Anspach gave this example. Currently, the standard deduction is $25,100 plus $1,700 per person over age 65. In 2021 that is $26,800 for a single tax filer, and $28,500 for a married couple. This component of the tax code is indexed to inflation. If you were going to be age 72 in 10 years, that standard deduction would be equivalent to about $38,000 in a decade at a 3% inflation rate. So, if you were following this type of plan, you would use a projected growth rate on your IRA, estimate your future RMDs and have a goal of converting enough that your RMD at age 72 was $36,000 if single, or at about $38,000 if married.

The problem with this approach is that it assumes the current standard deduction stays in place. With the 2017 Tax Cuts and Jobs Act (TCJA), current rates and the standard deduction are set to sunset, which means in 2026 the standard deduction could be less than half of the amounts just mentioned. Thus, the uncertainty of whether the current tax code will be made permanent makes it difficult to implement this type of plan.

“I don't know that zero tax makes sense to me,” said Anspach. “I'm a math person. I have to do the math. And what if you had to pay so much in taxes upfront that you have zero tax after this point but you can't ever recoup that cost. I think that is one of the factors that maybe people are missing when they have this goal of getting to zero tax.”

Looking at Marginal Tax Rates is Only Part of the Picture

“I always think there’s a better way than looking at simplistic rules,” said Anspach. “Rules of thumb are great. They get you thinking. They get you contemplating the relevant factors. But yes, there's a better way than simply looking at marginal tax rates.”

And that has to do with the effect additional taxable income due to Roth conversion can have on other aspects of your tax return and financial plan. For example, Roth conversion can impact:

  1. Your capital gains tax rates, at any age. For instance, long-term capital gains would be taxed at 15% instead of 0% for singles with taxable income of $40,400 and married couples with taxable income of $80,800. A taxpayer would have to calculate in advance whether a Roth conversion pushes their taxable income above those thresholds, for instance. 
  2. Your ACA premium tax credit, but only before age 65. If you are under age 65, and could potentially qualify for an ACA premium tax credit, the additional income will likely disqualify you, which could mean you pay thousands more for your health care than if you did qualify for the credit. 
  3. Your Medicare Part B (and Part D) premiums, which start at age 63. If you are age 63 or older, the additional income from a Roth conversion can push you into a higher modified adjusted gross income range that causes you to pay a higher Medicare Part B (and Part D) premium two years later. 
  4. How your Social Security benefits are taxed, which will impact you in the year you and/or a spouse begin collecting Social Security benefits.

On the flip side, when you do Roth conversions, it may lower your taxable income later in life, which could result in more capital gains being taxed at a lower rate, lower Medicare Part B premiums, and for lower-income households, it could mean less of your Social Security is taxed, according to Anspach.

“All of those factors come into play when you are contemplating a Roth conversion,” said Anspach.

And the very simple rules that look at your tax rate now and your tax rate later, don't incorporate all those factors. What’s more, the very simplistic online calculators don't incorporate the nuances of the tax code, either.

Instead, she said, “you need a model where you can plug in the Roth conversion and actually see the impact on all of these factors and decide: Does this improve your bottom line? Does this actually add value to your financial situation? And that's a challenging question to answer. If it was easy, we would all know what to do.”

What are some better ways? How could you measure it?

In her practice, Anspach has developed other ways to determine whether a Roth conversion makes sense or not. Those include:

  • Liquidation value or estimated total after-tax wealth at end-of-plan. One way that Anspach measures the success of a conversion strategy is to evaluate whether it increases the after-tax liquidation value at the end of the plan. One challenge, however, is if she’s working with someone who is age 55 or 60 today. The end-of-plan can be 30 or 35 years in the future. “It might be great that (someone is) leaving more wealth at the end of the plan, but that isn't always the goal,” she said.
  • Present value of required cash flows (withdrawals) for life. When you do Roth conversions you pay tax now but later it reduces your RMDs, and thus can reduce your later life tax bill causing the total needed withdrawals to be lower over your life despite the initial upfront tax cost. “That is an improvement in real cash flow to their financial plan,” she said. “But again, it doesn't tell me how much time it takes.” 
  • The question is, how long does it take to see the benefit of the Roth conversions? What is the breakeven? And some of the factors to consider when calculating a breakeven include current tax diversity; will the wealth be spent; longevity; asset location; and if married, the potential for one to spend many years later in life filing at single rates

In her practice, this analysis typically yields one of three outcomes: green, a definite yes; red, a definite no; and yellow, where conversations about the nuances are required before making a decision.

Read more about Roth conversions

When and for Whom Are Roth Conversions Most Beneficial? by Edward McQuarrie, a professor of marketing at Santa Clara University’s Leavey School of Business

Abstract

Much has changed since penalty-free Roth conversions were inaugurated in 2010. Tax rates have gone up and down. The re-characterization provision went away. Heirs can no longer stretch out inherited Roth accounts over a lifetime. Medicare surcharges were expanded and began to adjust for inflation. The age to begin required minimum distributions was pushed out to age 72 and the IRS changed the RMD divisor tables to further slow the pace of distribution. Given these developments, it seemed worthwhile to re-examine the rationale for Roth conversions. That effort exposed multiple flaws in conventional wisdom:
• Future tax rates need not be higher for a conversion to pay off;
• Nor is it all that helpful to pay the tax on conversion from outside funds;
• Nor are Roth conversions especially beneficial for top-bracket taxpayers as compared to middle-class taxpayers;
• Rather, the greatest benefit accrues to taxpayers who can make the conversion partly in the zero percent tax bracket, i.e., during a year with no other taxable income.

While the benefits from a Roth conversion are often small and slow to arrive, a Roth conversion will almost always pay off if given enough time, i.e., for life spans that extend past 90 and so long as annual distributions from converted amounts are not taken. Roth conversions work because of compounding, which requires the conversion to be left undisturbed for a long time. This paper elucidates the role played by the mathematics of compounding in underwriting the success of Roth conversions.