Roth Conversion: Is it a Good Idea?

 

I typed “Conversion of Traditional IRA to Roth” in Bing Image Creator; it generated four versions of images, all of which show a middle-aged man with gray hair at a desk full of papers and punching a calculator with a serious face. The image seems to aptly reflect the questions that arise more often as people approach retirement, especially for high-income earners who may face higher tax rates after retirement.

As I mentioned in my previous writing, to compare Traditional vs Roth IRA, Traditional IRA offers tax saving right away, while Roth IRA offers tax-free distribution in the future when you withdraw after retirement. As the famous Marshmallow Test conducted with preschool children by psychologist Walter Mischel has proved, human beings prefer instant gratification to delayed, better one. If you have to wait, you would ask, “Is it really worth waiting?”

Let’s dive into an example and analyze various scenarios to help determine if a Roth conversion could be beneficial. Based on the image above, let’s assume a 55 years old man with an annual Income of $150,000 and his current retirement portfolio consisting of Traditional IRA $400,000 and 401(k) $600,000, and he plans to retire and withdraw from 62. He is contemplating whether to convert some or all of his tax-deferred funds to a Roth IRA.

Key Considerations for Conversion:

For this decision of conversion, he would need to consider a few things:

1. Cost of Conversion: Converting all or a portion of the $400,000 from the traditional IRA would be taxed at the taxpayer’s current rate. Since he already earns $150,000 annually, any converted amount would be added to his taxable income, potentially pushing him into a higher tax bracket.
2. Growth expectation of Roth IRA: The primary benefit of a Roth account is that capital gains are tax-free. The more the portfolio value increases, the greater the benefit.
3. Advantages of Roth IRA:

- Tax-Free Growth: Any growth in the Roth IRA account would be tax-free, providing a future benefit. If his retirement tax rate remains at 22%, he will get tax-free income from the Roth in retirement, which could be useful if he has other sources of taxable income.

- Tax Diversification: Having a mix of Roth and traditional accounts provides flexibility in retirement, allowing the taxpayer to manage his tax liability more effectively.

- Simple estate planning (which will be discussed in a separate article)

Here, we’ll examine different scenarios with first both traditional IRA and Roth annual growth rate of 6%, secondly, moderate 12% annual growth rate of Roth, and then, 20% annual growth rate of Roth invested in highest risk, return portfolio, such as Bitcoin; each will be analyzed based on three different marginal tax rates in retirement.

Scenario A: Both Traditional IRA & Roth Annual Growth Rate 6%

Tax Rate Scenario 1: Consistent Marginal Tax Rate in Retirement (22%)

In this scenario, we assume that his marginal tax rate in retirement remains the same as it is now — at 22%. As the summary table shows below, when he converts to Roth, he needs to pay 22% tax now; then, the remaining amount in Roth will grow tax free. In cases of conversions, the total available fund after taxes at his retirement is less than the amount of no conversion case.

Tax Rate Scenario 2: Lower Tax Rate in Retirement (12%)

In this scenario, we assume he will just rely on his social security and retirement portfolios after retirement, which drops his marginal tax rate to 12%. Converting at the current 22% tax rate when he expects a lower 12% tax rate in retirement could be a disadvantage. He would essentially be paying more tax now than he might have to in retirement.

Tax Rate Scenario 3: Higher Tax Rate in Retirement (32%)

In this scenario, we assume his marginal tax rate rises to 32% in retirement. Converting now at the current 22% tax rate could result in significant long-term savings if his retirement tax rate is expected to be 32%.

In the scenario of reasonable, moderate annual growths of both IRA portfolios, the immediate tax hit of converting to Roth may not be worthwhile. Even in the case of a higher tax rate after retirement, the full conversion of the traditional IRA $400,000 at once would result in adverse outcomes. To manage such tax impact, he needs to consider staggering the conversions over a few years to avoid a large tax hit in a single year.

Scenario B: Traditional IRA Annual Growth Rate 6% & Roth Annual Growth Rate 12%

In this scenario, we assume he invests in a high risk/ return portfolio in a Roth account to maximize Roth’s benefit. The table below shows, except for the lower marginal tax rate after retirement, the full conversion results in the best for him. In the case of the lower marginal tax rate after retirement, the partial conversion gives a better result.

Scenario C: Traditional IRA Annual Growth Rate 6% & Roth Annual Growth Rate 20%

In this scenario, we assume he invests in a highest risk/ return portfolio in a Roth account to maximize Roth’s benefit. In this simulation, all cases show that the full conversion results in the best for him.

Conclusion:

1. Evaluate Current and Future Tax Rates: The primary factor in deciding whether a Roth conversion is beneficial is the comparison between the taxpayer’s current tax rate and the expected tax rate in retirement. The lower the future tax rate, the less advantageous the Roth conversion becomes. Some say tax rates will go up in the future due to the U.S. enormous debts.*

2. Consider Partial Conversions: Instead of converting the full amount at once, which could lead to a large tax bill, the taxpayer might consider converting smaller amounts each year as it spreads out the tax burden while still allowing for tax-free growth in the Roth.

3. Utilize Roth Conversion for Tax Diversification: Having both traditional (tax-deferred) and Roth accounts provides tax diversification, giving the taxpayer flexibility to control taxable income in retirement. This is beneficial regardless of which scenario ultimately plays out, as it allows the taxpayer to adjust withdrawals based on tax conditions.

4. Consider other implications such as no Required Minimum Distributions (RMDs) and simpler estate planning with a Roth IRA: Since the taxpayer will have RMDs from his 401(k) starting at age 73, adding a Roth IRA to his portfolio can give more control over when and how much to withdraw. Will discuss more about estate planning in the next article.

5. Consult a Tax Professional: Roth conversions are complex, and a professional can help evaluate tax implications, optimize the conversion strategy, and ensure compliance with tax regulations.

Resources>

*Check out a historical look at the U.S. top marginal income tax rate: https://www.wolterskluwer.com/en/expert-insights/whole-ball-of-tax-historical-income-tax-rates

**2024 Income Tax Brackets: https://taxfoundation.org/data/all/federal/2024-tax-brackets/