Should I do a Roth IRA conversion?
Like most investing decisions, deciding to execute a Roth IRA conversion is a move that could require you to accept some pain today in exchange for the promise of less pain in the future. In this specific case, the pain you are accepting today is one of the most-avoided and detested financial pains of all – paying taxes today when you don’t have to. It’s not fun today, and you’re probably not going to be thrilled with it tomorrow. But if the math checks out, it could be something that benefits you down the road, and that’s why Roth IRA conversions have to be something you examine, even if you ultimately decide not to do them.
Here’s the basic math you need to do to decide if you should do a Roth IRA conversion or not.
Unlike Roth IRA contributions, Roth IRA conversions do not have an earned income limit, meaning that you can do them regardless of how much income you make. That doesn’t mean that it always makes sense to do one, as the premise of a Roth IRA conversion is that you are taking funds from a tax-deferred Traditional IRA, paying the taxes today to remove the funds from the Traditional IRA, and transferring them directly into a Roth IRA, where the funds will then grow tax-free for the rest of your life. Pay the tax on the funds now and never pay taxes again. That’s the basic message when it comes to how the conversion works.
So the first things we want to identify are situations where you don’t want to do this. You likely do not want to attempt a Roth IRA conversion if you are in a high tax bracket today that is expected to decline later on. Here’s an example. Steve is a software engineer. He makes a boatload of money, well over $500,000, and he’s single. That means at the federal level, he pays 37% in taxes for every new dollar he earns. So if Steve decides he’s going to do a Roth IRA conversion for $10,000 from a traditional IRA he owns, that $10,000 will be treated as ordinary income and taxed at 37%, meaning he has to pay $3,700 in additional taxes this year. And that doesn’t even factor in potential state or city taxes. If Steve decides next year that he’s made enough money and he wants to go spend his time surfing, and his income goes down to $30,000, he is likely falling into the 12% federal tax bracket. So if he goes to withdraw money from his recently converted Roth IRA, he’s only saving 12% federally on every dollar he pulls out. He paid more tax to do the conversion than he would have if he had waited until he retired.
But now let’s look at the situation of Haley. Haley has been working for the last 40 years as an assembly line worker at an auto plant. She makes around $60,000 a year now, and her husband retired a year ago and isn’t earning any extra income right now. But over time, she’s saved over $1 million into her 401(k) plan, and she and her husband also have hefty pensions they are going to collect later on, in addition to Social Security. Today, Haley and her husband likely fall into the 12% tax bracket, which runs up to $80,250 in taxable income for 2020. But with their pensions, Social Security checks, and eventual required minimum distributions from their IRAs once they turn age 72, their income is likely to push them into the 22% tax bracket once all those income sources kick in. So in Haley’s case, the math is that a $10,000 Roth IRA conversion this year has her paying tax at 12% today, whereas they are likely paying at 22% in the future at the federal level.
This is the exact type of situation where a Roth IRA can make a ton of sense.
Now, these are really clear and simple examples. They don’t factor in things like Medicare premiums, state or city taxes, additional itemized deductions, or pretty much any type of complex tax situation. Oh, and these examples only look a year in the future, not multiple years where investment growth can potentially magnify either the benefits or costs of a Roth IRA conversion. For most people, those are questions for accountants to answer since we typically spend most of our days doing things other than analyzing the tax code. But the basic concept that you need to be familiar with is that a Roth IRA conversion has you paying tax today with the goal of saving taxes down the road. Accept some pain in the present with the promise of less pain in the future. Roth IRA conversions are not something that everyone should be doing – they are something everyone should be considering, because they can potentially result in significant tax savings if done properly.