Monday, May 20, 2024

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.

How:
  1. Grab your 2021 tax return and take a look at the very last line on page 1, Form 1040 (“Taxable Income”). That’s the amount of income that you were taxed on in 2021.
  2. Now, think about what’s different in 2022. Did you get a raise or see a jump in business profit? Will you have more itemized deductions this year? Use this information to make an informed estimate of what that number will be in 2022.
  3. Check out the 2022 tax brackets for your filing status and look for the row in the middle, the 24% rate. Now look for the amount that’s the most income that will be taxed at that rate. For example, a Single taxpayer can have up to $170,050 of income before crossing over into the next bracket.
  4. Subtract the result of #2 from the result of #3 to arrive at the amount you should consider for conversion. If the result is a negative number, the answer to the step is “no,” and you should not convert any amount. If the result is positive, the answer to the step is “yes,” and this is the upper limit of the amount you should consider converting.

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.

How:
  1. Determine the current tax cost of your Roth IRA conversion. Say you can convert $10,000 at the 24% rate. Your current tax cost will be $2,400.
  2. Make some assumptions to grow (or shrink, if that’s your outlook) your conversion amount assuming you never made the conversion.
  3. Use an assumed income replacement ratio to figure out what your highest tax bracket will be in the future (or at least when you assume you’ll actually use this money for expenses).
    1. For example, if you assume that future-you will have 80% of the income that today-you has, take 80% of your current taxable income to the tax table and see where it lands.
  4. Adjust for known changes in future tax rates (e.g., the 24% bracket becomes the 28% bracket in 2026).
  5. Apply the tax rate determined in #4 to the future portfolio value calculated in #2 to arrive at your future tax cost. Assume your $10,000 grows at 7.2% for 10 years and is worth $20,000 in the future. If you landed on 28% in #4, your future tax cost would be $5,600.
  6. Calculate the average annual rate of growth of your tax cost. To turn $2,400 into $5,600 in 10 years, the rate of growth must be 8.84%. In this example, tax-cost efficiency has been achieved because 8.84% is more than 7.2%.

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.

How:
  1. Do you expect your future tax rate to be lower? 
  • You already know the answer to this because you determined it when answering step 2. If for some reason, you’re still at this point — with a lower future tax rate — you likely have an edge case where your particular set of unicorn assumptions led you to tax efficiency even when paying a higher rate today than you would in the future. This is your reality check. Don’t convert if you think your future top tax rate will be lower than your current top tax rate.
  • Do you need this money within five years?
    • Again, this is another previously contemplated variable. If your “year of use” in step 2 was five years or less from now, it turns out that you do need this money within five years and you should not convert it to a Roth IRA now. Why? Well, if you do convert and you then take a full distribution from the converted Roth IRA within five years, you will need to pay tax — and possibly tax penalties — on the earnings that you withdraw. Need the money this soon? Don’t convert.
  • Do you have no heirs and no long-term care need?
    • If you answered “yes,” that you do not have heirs and you do not have a long-term care need, then doing a Roth IRA conversion may end up accelerating taxes to no one’s benefit. You probably know pretty well if you have heirs or someone to whom you want to leave your money. But are you sure you’ve made a long-term care plan that will stand the test of time? No matter the plan, there’s always the potential that shoring up your tax-free income sources could make your money last that much longer. If you’re absolutely certain that you have no one to leave your estate to and no need whatsoever to increase your available resources in a long-term care scenario, you probably do not want to convert.
  • Do you not have the cash to pay the taxes for the conversion?
    • The best is saved for last. You’ve made it two-and-three-quarters of the way through our three criteria, and this one is the real whopper: paying the tax today with cash from another source. Some will not be comfortable dropping a pretty large five-figure check when given the option. It’s totally understandable and why this step is here in this exact position. You’ve learned through this process that converting is very likely the right move. But if you simply can’t stomach writing this check, don’t. You don’t have to. You may end up paying more tax in the long run, but not today. If you’ve reached this point, it means that a conversion is advisable. So what? You’re an adult, and this is your choice.

    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!


    Jason Speciner

    About the Author

    Jason Speciner is a CERTIFIED FINANCIAL PLANNER™ professional, an Enrolled Agent, and the founder of fee-only firm Financial Planning Fort Collins. He is also a member of the National Association of Personal Financial Advisors (NAPFA) and XY Planning Network. Since 2004, he has served clients of all ages and backgrounds with unique experience working with members of generations X and Y.

    Did you know XYPN advisors provide virtual services? They can work with clients in any state! Find an Advisor.





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