The smile on your face after seeing how the multi-year bull market has increased your IRA/401(k) account could quickly turn into a frown once realizing how much in taxes you’ll pay when you begin taking Required Minimum Distributions (RMDs) at age 73 because they will be taxed as ordinary income.
Then you remember this legal loophole called a Roth conversion, which allows you to convert tax deferred assets (like your IRA/401(k)) into a Roth IRA account, pay ordinary income taxes on the amount converted in the year converted, but then withdraw the Roth funds tax free and at your leisure. In fact, the key goal of a Roth conversion is to reduce the total amount of taxes paid over a multiyear period compared to the taxes you would have paid with no conversion.
The only way to determine if a Roth conversion will be a success is to run various financial scenarios involving the amounts converted, future income and expenses, future taxes, future RMDs, and much more.
But before getting into the nitty gritty of the calculations involved in a Roth conversion, let’s go over some big-picture circumstances when a Roth conversion could be advantageous as well as when a conversion may not be worthwhile.
When conversion to a Roth IRA may be advantageous:
You think your taxes will be higher in the future because of higher income due, in part, to RMDs.
You think tax rates will increase. Example: the Tax Cuts and Jobs Act of 2017, which reduced tax rates, will expire at the end of 2025 unless extended by Congress.
You plan to leave assets to heirs whose tax rates will be higher than yours.
Your current income is low. That’s because Roth conversions are taxed as ordinary income in the year converted, so having low or minimal other taxable income will lower the tax bill.
Your assets are overly concentrated in tax-deferred accounts.
The value of the assets to be converted is abnormally low (like in a bear market), which results in lower taxes compared to converting them when they have a higher value.
Benefits after conversion to Roth:
Withdrawals and earnings are generally penalty and tax free, assuming you have waited five years and are older than 59 ½.
Since there are no RMDs on Roth IRA assets, you can withdraw Roth funds at your leisure.
Non-spouse beneficiaries of a Roth IRA can generally withdraw funds tax free if they follow IRS distribution rules like withdrawing all funds within 10 years.
Some disadvantages and when a conversion may not make financial sense:
A possible large federal and state tax bill in the year of conversion depending on the amount converted and your other sources of income.
Since conversions increase your income in the year converted, a higher portion of social security income may be taxed.
Being forced to sell taxable assets to pay the tax bill may result in even more taxes.
When future returns on your portfolio do not recoup the incremental taxes you will pay in the year of conversion, resulting in your total savings not lasting as long as if you were not to convert. This is particularly true when converting tax deferred assets with higher annual returns than the returns achieved on Roth assets, or when you are already in retirement and there is not enough time to recoup the incremental taxes via annual returns.
You must wait five years to take penalty-free Roth withdrawals, regardless of age.
When a beneficiary has a lower tax bracket than yours.
There are no do overs. You cannot “recharacterize” or undo a conversion.
Let our app crunch the numbers
Determining whether to convert assets into a Roth IRA involves complex calculations of future unknows like income and taxes. A key goal of a Roth conversion is to lower the cumulative taxes paid over a certain time period compared to the cumulative taxes that would be paid over the same time period if there was no conversion. The quicker the cumulative taxes paid after a conversion becomes less than the cumulative taxes paid assuming no conversion, the better.
And, conversions do not have to be executed all at one time but rather can be spread over a number of years, picking and choosing those years where it will be more beneficial.
So how do you accurately calculate many years of future income and taxes to determine if the conversion will be beneficial, especially when there are many combinations of years and conversion amounts to be considered?
The Relax Retirement Planner can make these complex calculations and provide instant feedback with a “before conversion” and “after conversion” comparison of several key variables, like taxes. You can run unlimited combinations of conversion amounts and conversion ages to determine the best combination. Plus, a Roth conversion analysis is only one of many “what if” contingencies that can be run to determine how long your savings will last.
Best of all, you can download a fully featured Relax Retirement Planner and run unlimited scenarios free of charge for 60 days. If satisfied with the planner, renew the license after the 60-day free trial for less than the cost of a dinner out for two. If not, simply do not renew. It’s that simple and risk free.