Beyond the Basics: Deciding Whether or Not to Do a Roth Conversion — A 3-Step Method
Much is made about the many methods to determine whether or not you should make a Roth IRA conversion. It seems as if this very strategy has been the quintessential tax planning move of the last decade since income limits and restrictions were eliminated in 2010.
As market volatility has caused losses in 2022, it’s also enhanced the opportunity for Roth IRA conversion. Lower prices mean creating less taxable income when converting the same number of shares of an investment. In short, Roth IRA conversions are on sale in 2022.
While that sale may make a Roth IRA conversion a real possibility, what’s harder to do is to determine whether or not it will eventually be worth it. After all, a Roth IRA conversion means you’re paying — and locking in— tax today in opposition to an unknown result in the future.
For this reason, I’ve developed a simple and straightforward three-step method for determining if you should make a Roth IRA conversion. In theory, this method will always be valid. However, it’s especially useful while the Tax Cuts and Jobs Act of 2017 (TCJA) tax rates are in effect. I’ll explain why later.
For now, let’s dig into the three-step method.
Determining a Roth Conversion in Three Steps
Step 1: Do you have room under the median (24%) tax bracket maximum?
The 24% tax bracket currently represents the largest opportunity for locking in a known difference between current and future tax rates. Say what you want about taxes going up or being higher in the future. This is a situation where it would literally take an act of Congress to stop the tax rate from increasing when the TCJA expires in 2026.
While almost every other rate will also go up with the expiration of the TCJA, the 24% rate will change the most. It’ll go up 4% — or an additional $4,000 per $100,000 of income — to 28%. The next stop in the current (and future) brackets is also 8% higher, at the 32% rate. This makes the median rate a perfect decision point. Capping the amount there will typically allow for a more “accessible” conversion amount (and resulting tax).
Consider all you want if you can squeeze more juice out of the difference between the top brackets at a 37% current and a 39.6% future rate. But always remember that it will take a six-figure tax bill today to learn if you’re right.
If the answer is “yes,” you are one step closer to determining if a Roth IRA conversion is right for you. If the answer is “no,” you can continue the process but your upfront cost will skyrocket.
Step 2: Can you achieve tax-cost efficiency?
Arbitrage: Risk-free profit from taking advantage of price dislocations in different markets. Imagine corn selling for $2 in one market and $3 in another. Assuming you could buy and sell corn in both markets, you’d sell all the $3 corn and buy all the $2 corn you could, on repeat, forever.
When I first developed this method, I wanted to call this “tax-cost arbitrage” but the reality is that, while it’s close, it’s not quite arbitrage. It’s not truly arbitrage because there is risk involved. Any time you could be wrong, arbitrage doesn’t exist because the wrong end of things represents risk.
In this case, the risk is simply that the assumption on future tax rate turns out to be wrong. Now, with that said, planning with known variables is far easier and almost always more accurate than planning with assumed changes. For tax rates, we know that they’ll go higher in 2026 unless Congress does something about it.
Alas, what we don’t know — and can only assume — is what our own tax rate will be at some point in the future. Our own tax rate changes not only because Congress does something but also because our income and deductions change. Plus, other factors — like inflation — determine where our last dollars of taxable income will hit the brackets.
All considered, you achieve tax-cost efficiency with a Roth IRA conversion when the growth in future tax cost on your traditional IRA (assuming you do not convert to a Roth IRA) exceeds your assumed rate of return on your underlying investments. For example, if you assume you will earn 7% on your investment portfolio but your tax cost would grow by 8% in the same period, you can achieve tax-cost efficiency with a Roth IRA conversion.
So, we don’t know what your tax cost will be, but we can make some pretty decent assumptions about it using today’s brackets and a reasonable income replacement ratio. Always remember that a Roth IRA conversion hinges on this one thing more than anything else. My method for evaluating it is simply one way to think through things, but I believe it has a certain logic that makes it appealing.
A “yes” to this question means that your money is more productively “invested” in tax savings on your portfolio than it would be invested in your portfolio. A “no” means that you are spinning your wheels and a conversion doesn’t make sense to consider.
Step 3: Are there any other reasons to not convert?
To this point, this exercise has been pretty objective. Yes, there are a few assumptions that you need to make. But on the whole, you determined the result using a binary response of some kind. Here, we’re looking for a “no” answer to be the final green light … but it’s not that straightforward.
The last step is a combination of objective and subjective criteria. In fact, step 3 is really a collection of four questions. Here’s how to evaluate step 3.
There is one narrow set of circumstances where step/question 3d can be a “no” but conversion is still feasible. If you’re over 59.5 years old and you have a long (15-plus year) time horizon for this money, you may want to take one final look at the future value of a conversion where you withhold taxes from the IRA itself. One obvious use case is that you don’t anticipate touching much traditional IRA money prior to being required to take distributions in the year you turn 72.
If you withhold tax on the conversion amount prior to age 59.5, you will owe a tax penalty on the withholding amount. And if you don’t wait long enough for the converted and withheld amount from your Roth IRA to grow, the entire exercise will have been a boondoggle and you will end up paying more taxes than had you just distributed from your traditional IRA later.
Assuming you finish the step-three gauntlet with every answer being a “no,” you will have reached the point where not converting your traditional IRA to a Roth IRA (in whatever amount you determine in step 1) will likely leave you worse off. You will pay tax on this money eventually, and this process has just helped you determine that the tax you pay today will be the lowest amount you’ll pay in your lifetime.
Here’s to happy tax planning!
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