Roth Conversions: To Convert or Not to Convert? It Depends
When you hear the word “convert,” you probably think of something other than retirement accounts. Converting that extra room to a recording studio, maybe, or converting an itinerant blog post reader to a client. (Ahem.)
As a financial planner, my mind jumps to a hot-button issue in the financial world: converting assets in a Traditional IRA to a Roth IRA. Roth conversions, as we call them, trigger taxable events, allowing people to pay taxes today on funds that will keep growing throughout their lifetimes. When the time comes to make withdrawals, Roth converters and their heirs can withdraw the funds tax-free.
Last year, House Democrats proposed a rule that would eventually forbid Roth conversions for people making more than $400,000 ($450,000 for couples). The rule didn’t pass, but the heat is officially on, and Roth conversions for wealthy individuals’ days may be numbered.
With federal Roth regulations in flux, clients often ask me whether they should take advantage of Roth conversions while they can. In each of these conversations, I start with the answer everyone loves to hear: “It depends.”
“It depends” may be no fun to hear. But the reality is, Roth conversions are very complex, and many factors influence the decision. I recently wrote a long note to a client explaining the nuts and bolts of Roth conversions. It occurred to me that many others might benefit from this information.
For those of you wondering about whether Roth conversions make sense for you, let me preempt the question by saying, “It depends.” In this article, I outline what exactly it depends on.
1) Backstory: Where did the Roth come from?
The Roth was created in 1997, when Republican Senator Richard Roth proposed it to Congress. The resulting Roth IRA (individual retirement account) was designed to allow middle-income Americans to save for retirement in a new way: pay taxes now, never pay them again.[1]
But in my experience, Roth IRAs ended up benefiting American families with higher incomes. How?
2) Late 1990s: Teenagers get a head start on retirement
I had my first Roth IRA when I was 14 years old. My parents weren’t wealthy, but we received an advertisement for Roth IRAs from Charles Schwab. My dad was shrewd enough to see the opportunity, and began contributing approximately $1,000 each summer to a Roth IRA in my name. He even set up a “matching” system, where I’d contribute my own money, and he’d match it like an employer.
In a more extreme version of this scenario, truly wealthy people began maxing out Roth IRAs for their teenage children.
To understand how this works, imagine a family with three teenagers working at a country club as caddies or lifeguards. As of 2022, parents can stash $6,000 pear year in each child’s Roth IRA using money taxed at the children’s income tax rate (very low for summer caddies and lifeguards), and the money is never taxed again.
3) 2000s: Roths become more accessible, even to doctors and lawyers
In 2001, regulators began allowing Roth contributions to employer plans (401k, 403b) irrespective of income level. Roths used to benefit only lower-income workers — the paralegals, not the lawyers. Now, they benefited both.
Then, in 2005, an even bigger opportunity arose. Regulators began allowing Roth conversions irrespective of income level. In simpler terms, rich people could pay taxes on their IRAs today in exchange for never paying them again. This was presumably pitched as a way to increase tax revenue in the short-term. But now, at the beginning of 2022, guess what…
In my experience, Roth has disproportionately benefited upper middle class and wealthy individuals. We all have different definitions of “wealthy,” but Roths have helped out the lawyers much more than the paralegals they were pitched to assist.
Now, people are outraged (especially after Peter Theil accumulated $5 billion tax-free Roth dollars), and pressure is mounting on lawmakers to crack down on giant (especially Roth) IRAs.
4) Roth Conversions: The window is closing
I recently wrote a two-part article on the death of the Mega Backdoor Roth. Now, there’s talk about eliminating Roth conversions altogether within a decade or so. If I had to guess, I’d anticipate regulators allowing Roth conversions for another 5-10 years for people with annual incomes below $400,000 (or $450,000 for married filing jointly).
Why not sooner? Because outlawing Roth conversions right away would reduce tax revenues. A 5-10-year window also gives Republicans and Democrats a compromise: at least they can tell their constituents that they have a few more years to take advantage of this strategy.
But no matter how you look at it, the window is definitely closing.
5) “Should I do a conversion?”
In many cases it makes sense, but figuring out the dollar amount is the tough part. Should you convert $10,000 or $100,000?
It depends on your current tax bracket versus your expected tax bracket in the future. Is it a “good deal” to pay the taxes now?
New York $20,000 Freebie
New York residents, this one’s for you.
If you are over age 59.5, New York offers an exemption of $20,000 of retirement income ($40,000 for married couples). Even if you’re still working, you may want to consider conversions during this timeframe. This is a “coupon” that the state of New York offers once a year. You can perform a conversion without needing to pay any state or local taxes. This is very much a case-by-case basis, but can make tremendous sense depending on your circumstances (it’s especially beneficial if the client’s heirs expect to live in New York or another high-income state long-term).
Other Considerations
Does the client have non-retirement assets that they can use to pay for the conversions? If the client has ample cash reserves, some amount of conversion is a no-brainer.
Should the client sell appreciated securities or use home equity to fund Roth conversions? Maybe — this is a highly circumstance-specific strategy.
What if the client is “retirement rich” — has millions in an IRA, but not much else? This is my personal favorite, because I enjoy a challenge. Lots of people in the Northeast fall into this category. They saved so hard for retirement, investing well, but most of their cash went toward raising kids, paying tuition, home improvements, etc.
For “retirement rich” people, I encourage regular withdrawals up to certain tax “sweet spots.” Pay the taxes, and reinvest the funds in a non-IRA. This can be challenging for people to swallow, but given the disparate tax treatment on different account types and the step-up in basis, it often makes a lot of sense. It’s especially beneficial if the IRA is very large.
Plus, with the elimination of the Stretch IRA, it is often better for account owners to pay taxes now (again, not always easy for people to accept) than for their beneficiaries to pay them later, when they’re in a high tax bracket. I model this using software so clients can understand the differential.
Extreme Example
Let’s suppose you’re a successful professional making $400,000 a year with an abundance of cash in your savings account. You decide to take a year off — maybe for a sabbatical, maybe just some time between jobs. That year, you have no salary, so you temporarily fall into the a much lower tax bracket. In this case, you would almost certainly want to do a conversion. You could convert tens of thousands of dollars at a 12% tax rate, compared to the 35% you’d pay in a regular income-generating year.
6) R.I.P. Stretch IRA
Handling IRAs used to be pretty cut-and-dry: Parents hold off paying any taxes, then the kids inherit the account, withdraw the bare minimum each year, and “stretch” out the account for their lifetime.
That all changed with the passage of the SECURE Act in 2019. With few exceptions, if you leave an IRA to a non-spouse, the beneficiary has to withdraw all funds within 10 years. My general rule of thumb: If you can afford to pay 22% (or even 24%) without paying state income taxes on a Roth conversion, it’s almost always a good deal.
Why? Because you (or your heirs) will never pay taxes on that money again. Tax rates aren’t going down for most of the people who can afford to do these conversions. Whether or not you fall into this category depends on the state you live in today, where you expect to live in the future, and the same for your heirs.
Once you get into the 32% federal tax bracket (~$160,000 for singles, ~$330,000 for couples) the question gets tougher, and we have to be much more thoughtful before doing conversions.
7) Example: Firefighter in Texas or Surgeon in Beverly Hills?
Suppose a client has $1 million in a traditional IRA, along with $750,000 in home equity and $100,000 in cash. Should she do a Roth conversion?
If she has a son who works as a firefighter in Texas making $50,000 a year, my analysis would be much different than if she has a daughter who works as a surgeon in Beverly Hills making $500,000 a year.
Why? Because the son in Texas is in a low bracket and pays no state income tax. He might pay around 20% tax on an inherited IRA, whereas the surgeon daughter could pay as much as 50% tax. State and federal tax disparity can heavily influence the decision to do a conversion, especially when you have multiple beneficiaries in very different financial circumstances. (In fact, it doesn’t always make sense to leave IRAs to children in equal pieces.)
8) When a Roth conversion makes no sense
If you plan on leaving a lot of money to charity, that’s a vote against the Roth, because the charity won’t pay tax on a Traditional account. There are also QCDs, which I see a lot with people who make religious donations over the age of 70.5. They write a check to their church/synagogue from their IRA (up to $100,000 a year) — a tax-free distribution. In that case, there is no value whatsoever in doing a Roth conversion.
What if you have a favorite nephew with a disability and plan to leave him a nest egg? You might want to leave traditional IRA dollars to him. Even with the new law, he may qualify for an exception, and still be able to “stretch” the IRA. Presumably, he’s in a lower tax bracket than the aunt/uncle. Another strong vote against the Roth.
What if you have no kids and want to leave your IRA to a sibling or friend (assuming they’re not more than 10 years younger)? They, too, can “stretch” the IRA. While it’s highly circumstance-specific, this is an instance where a Roth conversion is not so compelling, unless the “arbitrage” is so large that it’s an easy decision.
…That’s not all, but that’s all for now
Much as I want to discuss other factors it depends on, I’ll leave it there for now. Put simply: There are some scenarios where a Roth conversion is a no-brainer, others where it makes no sense at all, and others yet that fall somewhere in between.
If this article piqued your interest, I invite you to set up some time to talk with me.
[1] *to clarify Traditionally (hence why they are called Traditional IRAs and Traditional 401(k) contributions) you received a tax deduction upfront and paid the taxes later — a strong incentive for people to defer part of their paycheck to retirement.