A Deep Dive into Roth Conversions

Should you convert a traditional IRA to a Roth IRA? It depends on many factors. Bruce Larsen guides readers through some of the fundamental considerations of when a Roth conversion and shows how different variables influence the bottom line.

Table of Contents

Converting a Traditional IRA to a Roth IRA

There are many factors to consider when deciding whether to convert a traditional IRA to a Roth IRA. The advantage of a Traditional IRA was the deduction taken when the account was funded while the disadvantage is that when funds are withdrawn they will be taxable. The advantage of the Roth is that distributions, subject to some limitations, are tax-free when withdrawn but you received no deduction when the account was funded.

The assumption of contributing to a traditional IRA or 401(k) has been that your effective tax rate will be lower in retirement than it was while working. For most people this assumption is correct.

Taxes in Retirement Class
Parker, Arvada, Windsor
February 6th & February 8th
2019’s SECURE Act dramatically changed the rules and regulations for retirement plans. Learn how to take advantage of these new opportunities as well as strategies to protect your retirement income.

John and Mary Roth: Example IRA Conversions

Tax liability on a traditional IRA

As you know from reading my blogs, I always show concepts with an example. We will look at John and Mary Roth. Each earns $100,000 per year. If they make no 401(k) contributions and have no other deductions, their total federal and Colorado taxes will be $37,574—leaving them $147,126 in net after-tax cash flow. If they contributed 10% ($10,000) each to their 401(k)s they would have total taxes due of $32,217. Their net after-tax cash flow is $132,483. Their $20,000 in combined contributions only reduced their cash flow by $14,643 due to the tax savings they realized on the top line deduction for the contributions. That is a good deal—it cost them $14,643 to save $20,000, and they probably picked up a company match.

Their effective tax rate on taxable income is 21%. Assuming they saved in the 401(k)s, let’s look at their effective tax rate once they retire. Because of their earnings, they will have relatively high Social Security benefits—we will estimate each benefit at $2,600 per month, giving them each $31,200 annually. To achieve the same net after-tax cash flow in retirement, they will have to distribute $90,300 from their 401(k)s—or IRAs if they rolled them at retirement. 

This gives them a tax liability of $20,233; $12,064 less than they paid in combined federal and Colorado taxes while working. Their effective rate on taxable income is 17.5%. Their effective rate didn’t drop very much, but their total tax bill was 37% lower – primarily because 15% of their Social Security is tax-free and they don’t have the drag on their cash flow because of the 7.65% they were paying in FICA/Medicare taxes while working.

Looking at the numbers when deciding if a Roth conversion is a good option

Where would they have been if their contributions would have been to Roth accounts? Well, because they could not deduct the contributions, their cash flow while working would have been $127,126. Their taxes in retirement would be zero because none of their Social Security would be taxable, so they would only have to take $70,083 out of the Roth accounts. 

Okay, so assuming they could live on $5,357 less, the Roth option probably would have served them better. Unfortunately, Roth 401(k)s were not available until recently so let’s go back to the assumption that all of John and Mary’s money was in traditional 401(k)s. Does it make sense to convert? Like most financial decisions—it depends.

If the combined balance of their 401(k)s is less than $2,250,000 they most likely shouldn’t convert. Because of where they are on taxes, each $1,000 of additional IRA distribution will cost them $266 in taxes—giving them a marginal federal and state rate of 26.6%. If they tried to convert $100,000 it would cost them $27,527 in taxes. The marginal rate on the conversion is 27.5%. This is assuming they have the money from non-IRA sources to pay the taxes on the conversion. If they had to take the taxes out of the IRA to get $100,000 converted to a Roth, they would have to distribute another $40,000. Assuming no other funds available for taxes, the 40% marginal rate on the net conversion probably makes little sense. If they are on Medicare, they will pay earnings penalties for the year of conversion of $5,200.80, so the total ‘cost’ of conversion is about $45,000.

Just taking things this far, John and Mary may decide that a Roth conversion makes little sense. When I project out over a long period, Roth conversions typically only work if, at some point in their lives, John and Mary will have required minimum distributions (RMDs) that exceed their cash flow needs. If this is the case, they will pay taxes on money they don’t need and, unless they use an effective shelter strategy for the excess, they will pay more taxes on the buildup of funds.

Required minimum distributions and how they can impact a Roth conversion

Let’s assume John and Mary were over-achievers in their 401(k) savings, resulting in excess distributions when they reach RMD age of 72. Assuming they go into retirement at 67 with combined balances in 401(k)/IRA of $3,500,000 they will need about $101,826 out of the 401(k)/IRA accounts at age 72—assuming a 2.5% inflation rate. If the accounts earn 6%, their age 72 RMD will be $155,654. This gives them about $25,000 more in net cash flow than they need after the additional taxes on the excess of about $17,000 are paid. It most likely also puts them in a permanent Medicare penalty situation.

Once again, if RMDs are expected to be more than needed, strongly consider a Roth conversion. While you will spend additional money on the conversion, you will come out ahead—typically—if you live to normal life expectancy.

Other factors to consider in a Roth conversion

There are other factors to consider as well. The amount of taxes we will pay is ever-changing. At any time congress can increase or decrease taxes. If the 2018 tax cuts are allowed to sunset at the end of 2025, most retirees will see a tax increase of between 15% and 30%, making a Roth conversion more attractive.


What you need to know

While it is called the SECURE Act, it is really a mixed bag of new regulations – some good and some bad. The main two aims of the legislation seem to be to encourage more retirement savings and to increase tax revenue the government derives from IRA distributions. Whether you come out ahead is based on your individual circumstances. The Presidential SECURE Act guide outlines the key retirement savings provisions. 

Other variables to consider are the IRA regulation changes resulting from the passage of the SECURE Act at the end of last year. One reason to convert traditional IRAs to a Roth is for estate reasons. Prior to the SECURE Act, kids or grandkids inheriting an IRA could stretch distributions out over their lifetimes; they now will have to entirely distribute inherited accounts within 10 years. While inherited Roths are under the same distribution rules, at least what is coming out is tax-free to the beneficiary. The conversion decision often comes down to who you want to pay the taxes—you or the kids/grandkids.

One other consideration we should all keep in mind is that taxes are “on sale.” We currently have some of the lowest tax rates most of us have ever seen. With the national debt reaching a point many consider unsustainable, we should factor the likelihood of a large tax increase into a Roth conversion analysis.

The Best Way to Determine if a Roth Conversion Makes Sense is to Simulate Multiple Conversions

The only good way to analyze whether a Roth conversion makes sense is to simulate a conversion, or a series of conversions, and see if you are better off after the conversion(s). We can also factor in assumptions such as whether the 2018 tax cuts sunset or remain. We can also change tax increase assumptions—increasing them 10%, 15%, 20%—whatever you feel is most likely.

Bruce Larsen

Senior Financial Advisor, NSSA®, Certified Estate Planner™

Bruce is a featured speaker at Presidential Wealth Management workshops and also provides continuing education to tax preparers.  Bruce is a certified National Social Security Advisor. He is the “go-to” guy in the office for federal benefits issues, pension analysis, estate planning and special needs planning for disabled adults and children.

Bruce is also a published author. You can find his book, A Concise Guide to Taxes in Retirement, on Amazon in print or e-book format. It’s a no-nonsense overview of common tax situations one might face in retirement. 

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