How much to convert to Roth?
“I still don’t know what to do!” My husband said to me after reading my previous blog Roth Conversion: Is it a Good Idea? I intended to write a sequel on this topic, but with Thanksgiving and December quickly approaching, time has been flying by like a rocket, and I’ve been hardly able to find a spare moment. As Roth conversion needs to be done by the end of December, there's not much time left for 2024. So let’s dive in.
The only certainty in life is the uncertainty of not knowing what tomorrow holds. If death comes unexpectedly early, a traditional IRA or 401(k) could drop a tax bomb without a proper estate planning.
Let’s assume a man with $1 million in 401(k) who passed away at 62 just before his retirement. How this inheritance would work can be different depending on its beneficiaries.
Spouse Beneficiary Options:
Roll Over to Own Account: The spouse can roll the inherited 401(k) into their own 401(k) or IRA. This option allows the funds to continue growing tax-deferred.
Spousal Inherited IRA: The spouse can treat the 401(k) as their own inherited IRA, meaning they'll use the Uniform Lifetime Table for required minimum distributions (RMDs). They can start RMDs when the deceased spouse would have turned 73.
Lump-Sum Distribution: The spouse can take a lump-sum distribution, which results in immediate taxation of the entire amount as ordinary income and may result in a large tax bill.
Non-Spousal Beneficiary Options:
10-Year Rule: Under the SECURE Act, non-spousal beneficiaries must deplete the inherited IRA or 401(k) within 10 years following the account holder’s death. The beneficiary can roll the 401(k) into an Inherited IRA, allowing the funds to grow tax-deferred during the 10-year period.
Lump-Sum Distribution: The beneficiary can choose to take the entire amount as a lump-sum distribution. This option involves immediate taxation of the full amount as ordinary income.
Impact and Considerations:
- Taxes: Rolling the 401(k) into an IRA or another eligible retirement account may help in deferring taxes, but taking a lump sum can result in significant immediate taxes.
- RMDs: Understanding the timing and amount of RMDs is crucial to avoid penalties and optimize tax impact.
- Financial Planning: It's beneficial to consult with a financial advisor to optimize the withdrawal strategy and understand tax implications fully.
Because of these complexities, generally Roth IRA is recommended. That’s why many financial advisors advise Roth IRA conversion. Particularly, the temporary tax cuts from the 2017 Tax Cuts and Jobs Act (TCJA) sunset after 2025. Considering 2026 tax rates will rise after the TCJA expires, it would be better to convert portions of traditional IRA to Roth in 2024 and 2025. Then, the next question would be how much each year to convert.
<Table 1: How 2026 Tax Rates Will Rise if the TCJA Expires>
For this question, first, you need to understand your current tax bracket. For an example, let’s assume that last year (2023), your taxable income was $140,000 and your tax filing status is MFJ. Assuming your taxable income for 2024 is similar to last year’s, your marginal tax rate will be 22% for about $66,700 of additional income (the amount converted from traditional ira to roth will be considered as ordinary income), 24% for $187,900 of additional income, 32% for additional $106,450, 35% for additional $250,550 and 37% for any additional amount.
<Table 2: 2024 Tax Bracket>
Let’s assume you consider a partial conversion of $240,000 (you are willing to pay 24% tax now for future tax free withdrawal). You want to check whether this conversion would be a good decision. You may check it out here:https://wealthchannel.com/tools/ira-conversion/
Assuming your tax bracket (22% federal + 5.75% state) stays same after retirement, annual investment growth rate of 8% and dividend rate of 2%, this simulator gives answer as follows:
“This calculator runs two scenarios -- "Convert" and "Don't Convert" -- and then compares the values to determine which is optimal.
"Convert" Scenario: If you convert today, the value of your Roth IRA at retirement will be:
$411,318
"Don't Convert" Scenario: If you don't convert today, the after-tax value of your investments at retirement will be: $399,362
Conclusion: Based on these assumptions, you're better off if you Convert to a Roth IRA today. This decision will mean you'll have an extra $11,956 vs. not converting to a Roth IRA.
"Don't Convert" Methodology
If you do convert to a Roth today, you'll owe taxes of approximately $67,200; If you don't convert, you'll be able to invest this amount in a taxable account, and it will grow at a rate of 7.60% to $112,216 before taxes. This account is taxed at a capital gains rate of 20%. You will owe $9,003 in taxes on this account.
If you don't convert to a Roth, your Traditional IRA will grow to a pre-tax value of $411,318. In this scenario, you owe taxes on withdrawals. Based on your estimated marginal tax brackets in retirement, total taxes are $115,169
That means that the net value in the "Don't Convert" Scenario is:
$112,216 - $9,003 +$411,318 - $115,169 = $399,362
If you increase your current federal tax bracket to 24%, $240,000 conversion now will give you an extra $4,583 vs. not converting to a Roth IRA. Above this tax bracket, no conversion will be better.
Limitations: There are a few limitations to this model.
1) It assumes that you pay all of your taxes in retirement at once. In reality, you would likely pay taxes gradually as you withdraw from your non-Roth IRA.
2) It assumes that Roth IRAs won't become taxable. Remember that politicians hate you, and are always looking for new revenue streams. It's possible that they decide to diminish the tax efficiency of the Roth IRA.
3) It doesn't take into account the benefit associated with making "backdoor Roth" conversions in future years.
You may be better to convert $240,000 from traditional ira to roth in 2024; however, if your age hasn’t reached 59 ½, you have to make sure you have funds to pay additional Fed and State taxes of $70,200 (calculated roughly as $60,000*22%+ $180,000*24%+$240,000*5.75%). If you’re older than 59 ½, you may withdraw from your IRA without penalty for this estimated tax. This amount needs to be paid by Jan. 15, 2025 as the estimated tax to avoid any penalties of underpayment.
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