Roth Conversion: A Case Study

I have been a fan for many years of investors building their tax-free (Roth IRA) bucket as large as possible. The long-term tax-free benefits make the Roth IRA a much better choice than saving money in a tax-deferred (traditional IRA or 401(k)) bucket. When the SECURE act was passed in late 2019, Roth IRAs became even more attractive from an estate planning standpoint.

Prior to the SECURE Act, a person could leave their traditional IRA or Roth IRA to a non-spouse beneficiary (such as a child or grandchild), and the beneficiary could withdraw the money over their lifetime based on an actuarial chart provided by the IRS. There were “Required Minimum Distributions” (RMDs) each year, but they were relatively small when a young person inherited an IRA. The RMDs were taxed as income to the beneficiary for traditional IRAs, but only on the amount withdrawn each year. Many middle-income investors had planned on leaving their traditional IRAs to their children or grandchildren, and taking withdrawals over the lifetime of the beneficiary worked very well. RMDs were also required for Roth IRAs that were inherited, but Roth IRA withdrawals were not taxable.

The SECURE Act changed the rules drastically. Now, when a non-spouse (note this does not apply to spouses who inherit an IRA; they follow the old rules) inherits a traditional IRA or a Roth IRA, the money must all be withdrawn within 10 years following the death of the deceased owner. This can cause a tremendous tax burden when a non-spouse inherits a large traditional IRA. The distributions can be scattered throughout the 10 years in any way, but the full amount must be withdrawn by the 10-year mark, and the full amount is taxable income to the beneficiary.

A Roth IRA that is inherited by a non-spouse beneficiary must also be withdrawn within 10 years, but the distributions are not taxable.?

My recent articles have discussed the three ways to fund a Roth: (1) Fund it each year with $6,000 if you are under age 50 and $7,000 if you are age 50 or over (see IRS.gov for income limitations); (2) fund it through contributions to a Roth 401(k) or Roth 403(b) through your employer; or (3) convert a traditional IRA to a Roth IRA.?

Below are the facts for a theoretical couple who want to convert a significant amount of their traditional IRAs to Roth IRAs. This article does not contain tax advice, because every investor has a unique situation. You will need to talk with your financial advisor or tax preparer, or do your own research to determine if a Roth conversion is wise for your particular situation.

A Case in Point

Marcia and Ted are financially secure and wealthy. They have had successful careers, and they have saved and invested wisely over many years.

Taxable accounts = $1.2 million

Marcia’s traditional IRA = $1.1 million

Marcia’s Roth IRA = $700,000

Ted’s traditional IRA = $1.3 million

Ted’s Roth IRA = $500,000

Marcia and Ted have two grown sons, who have established careers. The sons are not in a low tax bracket.

Marcia and Ted have set a goal over the next few years of moving a significant amount from their traditional IRAs to their Roth IRAs.?

They converted $100,000 from Ted’s traditional IRA to his Roth IRA in 2021, and they are hoping to convert another $150,000 each year for the next few years. If possible, they would like to get both of their traditional IRAs below $1 million (before they each turn 72), and maximize the Roth IRAs. They will analyze their income and tax estimates each year to determine how much they will convert. If taxes increase significantly, they may decide to stop the Roth conversions.

Ted is 66. He retired in 2019, has a pension, and is on Medicare. He has not started drawing Social Security benefits. Marcia is 63 and plans to retire in 2022. She will not have a pension.

Marcia and Ted own rental property that provides them with income, and Marcia is still earning a salary. Their taxable investment account provides them with dividends and interest, as well as taxable capital gains. They are very charitably inclined and transferred $50,000 of appreciated assets from their taxable account to their donor-advised fund in 2021. They then distributed the $50,000 to several charities. Donating a significant amount to charity helps them manage their taxes each year.

Marcia and Ted estimate they will be in the top of the 22% federal marginal tax bracket in 2021, and in the 5% marginal bracket for state taxes. They estimated the taxes on the $100,000 Roth conversion they did in 2021 will cost them $27,000, and they paid the taxes as a quarterly estimated tax in 2021 from their taxable account.

In future years, their income will decline when Marcia retires. At some point, one of them will start drawing Social Security, and the other spouse will let their Social Security benefits accrue until age 70.?

They believe they have a “window of opportunity” for Roth conversions between now and 2026, which is the year before Ted turns 72, when he must start taking RMDs. Under current tax laws, the amount of the distribution for the first year is roughly 3.7% of the amount in the traditional IRA on 12/31/2026. If Marcia and Ted are successful at achieving their goal, his traditional IRA will be below $1 million so his RMD in 2027 will be under $37,000.

What Are the Benefits?

You may be asking yourself “Why would anyone be willing to pay $27,000 in taxes ($22,000 federal plus $5,000 state) to convert $100,000 to a Roth IRA?” The taxes seem excessive. For people with lower income, doing a Roth conversion will trigger far less in taxes. The case study of Marcia and Ted was used to show that even at a high tax rate, Roth conversions can often be justified. Here are the benefits:

1. When Ted and Marcia are both over 72, their RMDs will be significantly less than if they had not done the Roth conversions. This will reduce their taxable income each year beyond age 72. Roth IRAs do not require RMDs, so they can leave the Roth IRA accounts to grow and compound tax-free for their children.
2. They expect taxes to increase in future years. Based on recent proposals before Congress, households with income below $400,000 will not see tax increases. However, the national debt has increased so drastically, Marcia and Ted expect to see higher taxes in the future. They want to convert a significant amount to their Roth IRAs before taxes increase.
3. They have the money to pay the taxes from their taxable account.?
4. They have modeled this plan in retirement planning software, and the projections suggest that converting to Roth IRAs now will increase the overall value of their net worth when they are much older. (This is due to the powerful effect of large accounts growing and compounding tax-free over many years, combined with paying less taxes after age 72.)
5. Under current laws, their children or grandchildren will not be taxed when they inherit Roth IRAs.

What Are the Drawbacks?

Let’s take off our rose-colored glasses for a moment. Roth conversions have some cons. The major one is that taxes are due on the amount converted each year. In essence, you are paying taxes now rather than later.?

Other “cons” are that Roth conversions may cause a higher percentage of social security benefits to be taxed, and the premiums for Medicare Part B and D may be higher. (This is called IRMAA, which stands for Income-Related Monthly Adjusted Amount.) Both of these factors are impacted by income, so a Roth conversion (that increases income in the year of the conversion), may impact them. Marcia and Ted have already considered these factors in their calculations.

Who Should NOT Do a Roth Conversion?

Clearly, Roth conversions are not appropriate for everyone. Below are reasons you should not do a Roth conversion?

1. You do not have the money to pay the taxes in the year of conversion in a taxable account. (You should never withdraw more from the traditional IRA to pay the taxes.)
2. You expect to need all your money during your lifetime. In this case, there is no reason to do a Roth conversion.
3. You expect to be in a low tax bracket during retirement.
4. You expect your adult children will be in a low tax bracket if they inherit your traditional IRA.
5. You want to leave your traditional IRA to charity. In this case, the charity will not pay any taxes.
6. You are opposed to paying even one dollar of taxes sooner rather than later.
7. You expect Congress to change the rules, and eliminate the tax benefits and estate planning benefits of the Roth IRA.

The Upshot

The case study provided above describes a couple with high income and high taxes. For most readers, the tax “hit” for a Roth conversion will be far less than the estimates for Marcia and Ted. You will need to look at your personal situation.

Anyone can convert a traditional IRA to a Roth IRA, and you can convert any amount. If you have a $100,000 traditional IRA, you may want to consider converting $25,000 each year for the next four to five years. If you prepare your own taxes, you can run different scenarios using TurboTax or similar tax software.

After age 72, a person can still convert a traditional IRA to a Roth IRA. However, they must withdraw the RMD first during the year, and then do the Roth conversion.

Roth conversions require a waiting period of at least five tax years (to avoid any taxes or penalties), and the clock starts ticking again on each conversion. The owner must also be over 59? when taking a distribution to avoid taxes or penalties, although there are exceptions. Most people assume the money in their Roth IRA will be the last money they will spend, thereby leaving it to grow and compound tax-free for many years. Do not do a Roth conversion if you expect to need the money soon. There are many other variables to consider.??

Roth conversions are discussed frequently within the financial industry. With the changes caused by the SECURE Act and proposed (potential) tax changes, they are getting more press than ever. Moving money into a tax-free bucket seems like a very wise move!

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Donna Skeels Cygan, CFP?, MBA is the author of the award-winning book The Joy of Financial Security. She was a fee-only financial planner in Albuquerque for over 20 years, before recently retiring. She is now working on another book, writing articles, and speaking publicly for groups. She welcomes emails from readers at [email protected].?