When is a good time to convert from an IRA to a Roth?

Published by Gabe Fransen on

Mark Triplett | November 4, 2020

An attendee at one of our recent workshops asked us a question about Roth Conversions. Specifically, she asked “when is a good time to convert to a Roth IRA?” In short, the final two months of the year are typically when we really start acting to make final decisions about converting pre-tax money (such as IRAs, 401Ks, and other IOUs to the IRS) to never-taxed money (Roth IRA). However, there’s much more to consider before deciding to act.

“When is a good time to covert?” could be answered in several ways depending on the context of the question. Are we actually asking about the exact timing of the conversion in a given year, or are we asking whether we should be converting at all? These are two very different ways of interpreting the original question. We’ll tackle both perspectives in a handful of ways.

In this article we’ll talk about:

  • Long-term planning, and analyzing whether you should convert anything at all.
  • A framework for deciding whether to convert (or not) based on math, not emotional.
  • Ways to pay the taxes on the conversion?
  • 5 compelling reasons to consider converting pre-tax to never-taxed money
  • Timing of conversions – two times of the year when might strongly consider converting
  • Unique opportunities in 2020 resulting from the fallout of COVID-19.

In the end, you should have a better comprehension as to if and when you might want to consider taking some of your pre-tax IOUs to the IRS, and converting them to a never-taxed Roth IRA.

Long-Term Planning – Would a Roth Conversion Help or Hurt You?

How do you determine whether or not you should convert some of your pre-tax money to never-taxed Roth? How do you determine whether a Roth conversion is a good long-term decision for you? This question can be easily answered, but the analysis as to how much and when to convert is much more complex. Let’s start with the easy part.

Start by asking yourself the following two questions:

  1. Do I believe the progressive tax rates in the United States wil likely be higher in the future than they are currently?
  2. Do I believe my future combined taxable income will place me in a higher bracket than I am today?

Answer “yes” to either one of these questions, and converting some of your pre-tax money to a Roth IRA may make a lot of sense. You don’t need to make it any more complicated than that.

If your taxable income, and/or the taxable rate on your next dollar distributed in the future, is likely to be higher than it is today converting is likely a wise decision. The tax rate you pay is the only determining factor, regardless of rates of return or length of time you defer taxes.

For example, if your tax rate today is 22% (on your next dollar of earned income or taxable distribution from a pre-tax account), but in the future it is likely to be 25%, regardless of timeframe or rate of return, it makes sense to convert. On the contrary if you’re currently in a 32% tax rate and in the future you’re likely to be at a tax rate that is 24%, it may not make sense to convert.

What about lost opportunity cost?

One of the common objections to converting we hear revolves around the lost opportunity to earn a rate of return on the money that goes to pay taxes on a conversion. When you convert from an IRA to a Roth you have to pay taxes. Because you’re paying those taxes now rather than later it means those dollars don’t have the chance to grow. They are no longer “working for you” earning interest, or a rate of return if invested in the market. This belief prevents some folks from acting even when converting some of their money would benefit their long-term plan.

However, is this belief valid or a myth? The best way that I’ve been able to come up with to educate folks is a simple math equation. Let’s do this together.

I want to make this math is simple and easy for us to understand. Something we can really get our arms around. Using the rule of 72, we know that an account earning a 5.1% rate of return will double in value by the 14th year.

In other words, $100,000 would become $200,000 in 14 years at 5.1% compounded. Therefore, we’re going to assume a 5.1% rate of return and a 14-year period of time when evaluating whether or not a conversion would result in a lost opportunity cost.

Let’s assume you have a $100,000 IRA. This is pre-tax money, and you were trying evaluate whether you should convert it to a Roth IRA or not. To convert the entire account to a Roth you would have to pay taxes on the conversion.

When do you pay the taxes? Next year when you file your taxes for this calendar year.

We’ll assume a 22% federal tax rate plus a 5% state tax rate. Your total tax liability on the conversion is 27%, or $27,000. If you were to convert $100,000, and pay the taxes out of the money to be converted you would be left with $73,000 in never-taxed Roth IRA. $73,000 at 5.1% compounded over 14 years would equal $146,000 of never-taxed Roth IRA money.

What about the $27,000 that you paid in taxes? It’s no longer working for you, and therefore you may be thinking that the conversion is costing you opportunity to enjoy compounded interest on that money. Isn’t that right?

Assume for a moment that we don’t convert to a Roth. Your $100,000 pre-tax IRA is invested in earns the same 5.1% over 14 years. $100,000 with double to $200,000. It’s all pre-tax money so you will eventually settle up with the IRS. We’re going assume that your tax rate is the same as before. You will owe the 22% to the IRS, and 5% to the state for a total of 27% in taxes. 27% of $200,000 is $54,000 to be paid in taxes. If we subtract $54,000 from the $200,000 our after-tax balance is worth $146,000. You see, it’s the exact same result. Therefore, if you assume the same rate of return, the only thing that matters is the tax rate now compared to the tax rate in the future.

However, there is one significant difference to point out. Even though the balances may be the exact same in our example, the account types are quite different. The Roth is never-taxed money. Any interest or rate return that is applied to this account going forward will never be taxed! However, the after-tax account is subject to income tax on any interest credited and ordinary dividends received. Any realized capital appreciation on invested assets will result in capital gains taxes. Therefore, you might argue that the conversion is beneficial even if your future tax rates will be the exact same as they are today.

Are tax rates likely to increase in the future?

A question you might want to answer for yourself is, “do I believe taxes will be higher or lower in the future.” If we just compare the progressive tax rates from 2017 to current rates under the Tax Cuts and Jobs Act (which took effect in 2018 and run through 2025) we can see that tax rates did in fact decrease.

You may also notice that the tax brackets expanded making it more attractive to pay taxes at the 12%, 22%, and 24% tax brackets. There are even a few “sweet spots” in the 22% and 24% brackets where they overlap with what would have been much high rates from 2017. If no action is taken by Congress the TC&JA tax rates are schedule to sunset at the end of 2025, and revert back to the previous progressive tax rate scale from 2017.

Next, apply critical thinking to the federal government spending. Since the beginning of the COVID-19 pandemic the federal government has spent a lot of money to prop up the economy, and help families and businesses through this difficult time. The CARES Act, and subsequent legislation has added trillions of dollars in federal spending to an already ballooning annual US federal deficit.

Then there are the unfunded liabilities of our social insurance programs like Social Security and Medicare. These programs will continue to require greater and greater funding likely to result in the need for higher taxation of income in the future in order to sustain them.

If you really want to get an understanding of the magnitude of the US deficit view the US debt clock (https://www.usdebtclock.org/), but don’t linger too long. You’re liable to get overwhelmed and it may ruin your day. Just watch it long enough to understand that it may be better to pay off the federal government now rather than waiting. Let it motivate you to action, and take control over your future!

How should I pay for the conversion tax?

There are a couple of ways you can plan to pay for the taxes due when you convert from a pre-tax account to a never-taxed account.

You can:

  1. Pay for the conversion tax with additional distributions from your IRA, or
  2. Use after-tax money from another account. Nevertheless, the taxes have to be paid between January 1st and April 15th (tax filing deadline) following the year of the conversion.

If you choose to pay taxes out of pre-tax accounts one of two things happens. You either have less money going into your Roth because some of it was held to pay taxes, or you’ll have to take additional pre-tax distributions in order to pay the taxes on the conversion. The second action will cause additional taxation at your marginal tax rate. While Roth conversions may be done prior to age 59 ½ without a penalty for early withdrawal (because you’re not actually withdrawing the money), if you are under 59 1/2 and take distributions to pay the taxes on a conversion it will trigger a 10% penalty for early withdrawal from a retirement account. However, the penalty is only on the portion distributed to pay the taxes because it is considered a distribution and not a conversion.

Perhaps a more ideal way to pay for the conversion taxes would be to use after-tax money. For example, if you have money in a low interest savings account, a money market, cash equivalents in a brokerage account, or other low yielding cash accounts those would be an ideal to use to pay for the conversion tax. If you don’t currently have cash saved up and you’re planning ahead, you may start setting aside a little monthly savings in an account designated specifically to pay taxes on your next conversion. By using after-tax money, particularly low yielding savings in a taxable account, you will allow more of your pre-tax (IRA) money to be converted to never-taxed (Roth) money, avoid triggering additional income taxes resulting from pre-tax distributions, and avoid any potential for incurring early withdrawal penalties if you’re under age 59 1/2.

5 reasons to consider converting

Once you have determined that you are a candidate for Roth conversions based on the framework we provided earlier it may be productive to consider specific reasons for acting. The following circumstance are common compelling reasons to convert that we see in our practice over and again.

  1. You are likely to have high level of taxable income in retirement – For example, you receive a pension from your former employer. The lifetime of income provided by a pension is a valuable retirement resource. Consider yourself fortunate if you have one. However, understand that it will act as a baseline level of taxable income for as long as you live. This makes it nearly impossible to lower your annual taxable income below the cumulative monthly pension payments in a calendar year. Any distributions from pre-tax accounts like IRAs will add fuel to the tax fire so one of your best moves may be to proactively convert pre-tax money to Roth IRA money while your tax rates are low.
  2. You have large pre-tax accounts that are not going to be needed to sustain your lifestylethroughout retirement – They will result in ever-increasing required minimum distributions (RMDs) as you age. RMDs are mandatory distributions from pre-tax accounts beginning at age 72 (70 ½ prior to the passage of the SECURE Act -Dec. 19th 2019). If your RMDs are likely to be larger than the standard deduction (currently $27,400 for a married couple over the age of 65 for 2020) you may want to consider converting some of your pre-tax dollars to never-taxed Roth money before reaching age 72.
  3. You are likely to leave your beneficiaries large pre-tax accounts such as IRAs, 401(k)s and other IOUs the IRS – If you think they won’t be taxable when you are gone, you may want to think again. Someone will have to pay the tax whether it is you, or your heirs. The secure act of 2019 altered the way that pre-tax accounts are inherited too. Your beneficiaries can no longer keep those accounts in deferment for the rest of their life taking only required minimum distributions. Nope, they are now forced to distribute those inherited pre-tax accounts within 10 years. There’s no set schedule of required distributions over the ten-year period, but all of the account balance must be liquidated. As you can imagine, this will result in taxation of those assets by the end of the 10th year. Many beneficiaries will receive pre-tax inheritance from their parents during their prime income earning years – the time which they are most likely to be paying the highest taxes of their career. Now they’ll be forced to distribute pre-tax dollars on top of their earned income driving their tax rates even higher. A few may be planning for their children’s college education. Forced distributions of inherited pre-tax accounts could foreseeably impact their Free Application for Federal Student Aid (FAFSA) driving up their expected family contribution which would result in decreased access to financial aid. Yikes!
  4. Mitigating the Widow’s/Widower’s Penalty on a surviving spouse – As described in our August issue titled The Plight of The Retired Widow Part 2, it may make sense to start converting some of those pre-tax dollars now in an attempt to mitigate the likelihood that a surviving spouse of a married couple will be forced into paying higher taxes on income, social security benefits, and Medicare premiums. We won’t go into much detail about the Widow’s/Widower’s Penalty here, but you can review the article from August to get a better understanding of this reason for converting now. Click Here
  5. Taxes seem to be on sale – Under the Tax Cuts and Jobs Act (TC&JA) we’re experiencing historically low tax rates accompanied by wider tax brackets creating an extra incentive to pay off the federal government, and get them out of your retirement accounts forever. However, the TC&JA has a short lifespan. We have 5 years and a couple of months to take advantage of the current situation. That is if cash starved Congress doesn’t make any changes before 2025. Now is the time to be evaluating whether or not a Roth conversion will make a positive impact on your long-term written retirement plan and act.

Annual Timing of Conversions

Back to the original question. “When is a good time to convert to a Roth IRA?” If we take this literally, there are two specific times on an annual basis where we will advise clients whom are good candidates for Roth conversions to take such action.

  1. End of year planning is typically when we would make a Roth conversion decision. The SECURE Act, which we’ve mentioned so often in this article, eliminated re-characterization of Roth IRA conversions. Simply put, a Roth conversion is now a one-way street. You cannot go back and undo it. Therefore, we like to wait until the last two months of the year, get a solid estimation of a client’s income for the year. We do this by evaluating their pay stubs, adding in any potential compensation that was awarded from the previous tax year (like an end year bonus for 2019 paid in tax year 2020), and any extraordinary compensation they are likely to receive before year’s end. Once we have been able to make a solid estimation of their current tax year’s income we can begin to evaluate how much they may or may not want to convert. This is done by determining how much capacity they have remaining in their current marginal tax bracket before going over into the next highest bracket. We may want to take advantage of “Stuffing the Bracket” because if they don’t use it by the end of the year they lose it. Of course, they can convert the following year too, but they can’t go back and convert for the previous tax year after December 31st. It’s a decision that must be made before the end of the year.
  2. When a unique opportunity presents itself, we may look to convert some money earlier in the year. For example, in March 2020 the stock market suffered a severe downturn. It was the fastest on record. It presented an opportunity for those with investable assets in their pre-tax accounts like IRAs to convert at a steep discount. For example, let’s say you had $100,000 in an IRA. It was invested in the market. The market dropped 35%, and the value of your assets were now worth only $65,000. If you were to convert the account you would be responsible for paying conversion taxes next year, but would they be based on $100,000 or $65,000? Your conversion tax would be based on the closing market value of the day that you convert the assets. When the market recovers, and your account balance returns to pre-downturn levels it is all tax-free. The following year you are responsible for paying taxes on a $65,000 conversion, not a $100,000 conversion. As we say around the office, “when the market gives you lemons, we make lemonade!”

Unique 2020 Roth conversion opportunities.

There are two additional reasons to consider Roth conversions in 2020. Number one, if your income for 2020 has been reduced as either a result of retiring mid-year, or having been a disruption in employment due to the COVID-19 pandemic you may want to consider converting some of your pre-tax money. If your taxable income for 2020 is less than it was in 2019 (like when you retire mid-year), or you’re likely to have a higher income in 2021 than you are in 2020 (in the case of layoffs or furloughs followed by regaining full employment) take advantage by converting some of your pre-tax money in 2020 while your income is suppressed.

There’s another unique reason to consider conversions in 2020. If you were supposed to take RMDs in 2020 the CARES Act suspended them for tax year 2020. That means you don’t have to take them. Instead of taking the RMD for 2020 consider converting the amount you would have been forced to take. The resulting income tax is the same. However, you’ll be moving money from a pre-tax account to a never taxed account rather than from a pre-tax account to an after-tax account. Since RMD’s cannot be convert to a Roth, this year presents a unique opportunity to convert what would have been a forced distribution.

Final Thoughts

We’ve managed to cover a lot of ground. Just think, this was all to answer a single question asked by an attendee at one of our classes. As you can see, this is a complicated topic. There’s much to consider before you act. Your decision is final, and needs to be made by December 31st each year, so its best to investigate thoroughly and plan several moves ahead.

We would recommend that you work with a fee-based financial advisor who understands long-term retirement income and tax planning. It’s also advised to consult a tax professional before making any final tax related decisions.

Nevertheless, we’ve outlined several instances when you might want to think about conversions, laid out a frame work for deciding whether or not a Roth conversion is likely going to be a good fit for you, and shared five compelling reasons why you might want to consider converting some of your pre-tax money to never-taxed account.

As you make plans for your own transition from your working years to your post working years, look deep into the future. Ask yourself these questions?

  • How will the current structure of your retirement assets and income likely play out 20 years from now?
  • How would rising tax rates and shrinking tax brackets impact your lifestyle?
  • How would your surviving spouse be impacted based on the current path you’re following?
  • Are there things you can do today to proactively immunize yourself from future taxes?
  • What is holding you back from acting and seizing the opportunity?

If you’re finding it difficult to see into the future and answer these questions, our team at TWFG may be able to help. Use our Purpose and Timeline 5 Step Planning Process, sophisticated financial planning programs, and years of experience as a guide to uncover answers to the questions, and develop strategies that could help your family optimize Roth conversion opportunities.