3 Times It Makes Sense to Convert to Roth IRA

“Should I convert to Roth IRA?”

That’s a question I hear in nearly every initial consultation for retirement income planning.

And understandably so – who wouldn’t want to strategically minimize taxes during their retirement years after having paid taxes throughout their working life?

Having assessed numerous Roth conversion strategies, I’ve identified three primary reasons that may justify the conversion. In this article, we’ll delve into these three reasons, starting with the most evident one and progressing to two less-obvious factors that may still warrant consideration despite seemingly unfavorable figures.

But first, let’s clarify what a Roth conversion entails. Essentially, it involves transferring pre-tax savings, such as those in a traditional IRA or 401K, to a Roth IRA. The advantage of a Roth IRA is its tax-free growth and tax-free withdrawals during retirement (provided the required holding period is met). However, converting requires you to pay income taxes on the converted sum at your prevailing tax rate, which can be costly. Therefore, the crux of the analysis lies in determining if the upfront tax payment can lead to overall tax savings throughout retirement.

Reason to Convert #1) Decrease Your Overall Retirement Taxes

In our example, let’s consider a 62-year-old couple on the verge of retirement. They have an IRA valued at $800,000 and a joint brokerage account worth $400,000, with a total cost basis of $350,000 (this means $50,000 of the $400,000 is subject to capital gains taxes). The full retirement age social security benefit for one spouse is $3,300, while the other will receive a spousal benefit of half that amount, or $1,650. We could explore various social security strategies, but for simplicity, let’s assume they will file at full retirement age. Altogether, they want a net monthly income of $7,000 in retirement.

The primary question we’re addressing is:

Can upfront tax payments lead to overall lower taxes in retirement compared to spreading them out over the years?

The answer is relatively clear-cut.

For this couple, we examined multiple scenarios, with the best-suited one being conversion up to the lowest tax bracket. Once Social Security benefits began, they had limited room for conversions but managed to convert approximately $300,000, significantly impacting their retirement taxes. A cumulative tax comparison chart reveals that the Roth conversion (orange line) results in lower taxes by age 76. By age 85, the conversion results in a $65,000 benefit, and by age 90, there’s a $150,000 difference.

However, taxes aren’t the sole factor to consider. The total conversion cost, which may include higher Medicare premiums or increased ACA health coverage costs before 65, must also be evaluated.

Reason to Convert #2) You Believe Taxes Will Increase

The second reason to consider Roth conversions is the possibility of future tax increases. In a few years, the Trump tax cuts are set to expire, and simultaneously, the current administration is proposing tax hikes. This has led many to question the conventional financial planning wisdom that suggests pre-tax savings will face lower taxes in retirement. In reality, taxes are currently as low as they’ve ever been.

For instance, if you retired in 1980 with a gross annual income of $33,000 (which is roughly equivalent to $120,000 in today’s dollars), you would have owed around 23% in taxes, given the adjustments and tax brackets at the time. Comparatively, the same inflation-adjusted amount today would yield an average tax rate of about 13%. Thus, it’s not unreasonable to assume that tax rates may increase in the future.

However, current Roth conversion analyses don’t account for potential tax hikes, as this would require predicting the future. Presently, we assume that the Trump tax cuts will expire at the end of 2025 and the previous rates will return. If rates are adjusted higher, it could change the game.

I often tell my clients that financial planning is 1/2 data and 1/2 emotions. Retirement planning is an individualized process, combining data and emotions. You must examine a plan with real numbers and assess how you feel about them. If you’re fairly certain that taxes will increase in the future, you may want to disregard the Roth analysis even if it suggests that conversion doesn’t make sense based on current information.

Reason to Convert #3) You Want to Lower Taxes to Your Heirs

The third reason to consider Roth conversions is to reduce taxes for your heirs. In many cases, individuals save more than they will spend during their lifetime, often in an IRA or 401K. Although they will take distributions, they won’t deplete the balance before passing away. Typically, they are content with leaving the remaining funds to their children. However, many people are unaware of the recent changes in distribution rules for inherited accounts. Previously, heirs could spread distributions over their lifetime, but now they must empty the account within 10 years. This change can push heirs into higher tax brackets, resulting in more of the inheritance going to taxes than intended.

For instance, if you leave an IRA worth $1 million to your child, who is married and working, they could potentially pay 25% or more of the inherited IRA in taxes. In contrast, if the inheritance were in a Roth IRA, they wouldn’t owe any taxes. A key question to consider is: would you pay $100,000 in taxes to save your children from paying $300,000 in taxes? While the numbers will vary according to individual circumstances, this ratio is often applicable and provides another reason to consider a Roth conversion, even if it doesn’t benefit your own retirement.

Ultimately, I think that everyone should explore a Roth conversion analysis. While it won’t make sense for everyone, having the necessary data allows for informed decision-making. You don’t want to be left wondering at 75 if you should have converted. Gather the data, assess your feelings about the information, and make a decision. If you need assistance, our team offers Roth conversion analyses as part of every Retirement Roadmap plan. You can find more details and schedule a call here.