Tips on How to Determine if you should make a Roth Conversion - Rodgers & Associates
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Tips on How to Determine if you should make a Roth Conversion

I’ve written so much about making Roth conver­sions the past couple of years that people have begun to ask me if there is ever a reason not to convert. The answer is yes. So, in this issue of the newsletter, I want to take you through the IRA-to-Roth conversion thought process.

On paying Roth conversion taxes

We begin with the principle that it is always better to pay less tax than to pay more. No one wants to pay 30% in taxes on a Roth conversion today if they are reasonably sure their tax bracket will be lower in the future. The higher tax disad­vantage can be overcome if the money will be left in the Roth to grow tax-free for a long period of time. A financial adviser can help you determine a breakeven point.

How Social Security impacts a Roth conversion

Taxes are not the only obstacle to consider when doing a Roth conversion. Anyone drawing Social Security benefits will need to consider the impact a conversion could have on the untaxed portion of their benefit. Since 1993, up to 85% of the value of the Social Security benefit has been subject to income tax.

Retirees with provi­sional income below the base amounts of $25,000 (single filer) and $32,000 (joint filer) are not subject to tax on their benefits. Retirees with income above these thresholds will find that the tax applies to some percentage of their benefits. For joint filers with incomes above an “adjusted base amount” of $44,000, up to 85% of benefits can be taxed. The income thresholds are not adjusted for inflation.

A retiree in a 15% tax bracket could do a Roth conversion that keeps their income within the 15% tax bracket but makes more of their Social Security benefits taxable. The effective tax rate on the conversion could be too high to make the trans­action advisable.

An important part of the Roth conversion decision process will involve making forecasts about future tax rates and comparing them to your current tax rate. The place to start is to calculate your income needs in retirement.

Forecasting future tax rates to better understand the benefits of a Roth conversion

Let’s use a hypothetical income target of $100,000. Using The New Three-Legged Stool approach to planning, you will want some of this income to come from your Roth, your IRA/401(k), and your after-tax savings. Your after-tax invest­ments should all be in stock invest­ments. Histor­i­cally, stock invest­ments have generated 3% in dividends and 7% in capital gains. Use these numbers to estimate the taxable income from your after-tax accounts. You will be able to control the taxable income from your IRA/401(k) by the amount of the withdrawals you take each year (at least until you reach age 70 ½).

The maximum amount of taxable income for a taxpayer filing jointly to stay in a 15% tax bracket is $75,900 in 2017. Tax brackets are typically increased by the rate of inflation each year. You could use a 3% inflation factor to estimate your bracket in the future. Anyone in a 25% tax bracket now that estimates they may be in a 15% bracket in the near future may not want to do Roth conver­sions now.

Forecasting what Congress may or may not do with taxes in the future is risky.  Tax reform has been discussed for several years and many believe there is a good chance Congress may reform taxes in 2017. A national sales tax and a value added tax have been debated in the past. Neither of these taxes would have an impact on IRA withdrawals.

There is also the possi­bility that current retirees would be exempt from tax increases affecting IRA withdrawals. Roth conver­sions should be approached conser­v­a­tively for those that are near retirement. Those who are younger and thus have many years of tax-free growth ahead of them in a Roth can be more aggressive.

Recharacterization and undoing Roth conversions

You should always keep in mind that Roth conver­sions can be undone through a process called rechar­ac­ter­i­zation. Rechar­ac­ter­i­za­tions do not have to be done in the same year as the conversion. However, a taxpayer has until their filing deadline, including exten­sions, to complete the trans­action. That means conver­sions done during 2017 have until October 15, 2018 to be rechar­ac­terized.

While it is important to think about this for year-end tax planning, there is no urgency to get this done. Once you rechar­ac­terize, you cannot convert again until the new tax year or 30 days has past, whichever is longer. That is why it is usually a good idea to wait until the end of the year to rechar­ac­terize.

Rechar­ac­ter­i­za­tions are not all or nothing – partial rechar­ac­ter­i­za­tions are permitted. You can decide to rechar­ac­terize only a portion of the amount converted if doing so would avoid moving into a higher tax bracket. You can even pick and choose if you converted IRAs at different times.

Finally, the stock market should be considered when planning a Roth conversion.  Ideally, you would prefer to perform a Roth conversion when the stock market is down. This would allow you to convert assets at lower taxable values. A market rally following conversion would make all subse­quent growth tax-free in the future.

Rick’s Tips:

  • It is generally best to do Roth conver­sions when you are in a low tax bracket.
  • A conversion may not be advisable in a low tax bracket if Social Security benefits would become taxable.
  • Conver­sions can be rechar­ac­terized before the tax filing deadline to essen­tially undo the trans­action.