When is a Roth conversion beneficial?

By Robert A. Westley, CPA/PFS, and David M. Barral, CPA/PFS

This article focuses on some of the considerations that investors should assess when determining whether to convert a traditional IRA to a Roth IRA. These include not only expected future income tax rates but also the account owner's particular tax situation in the year in question, anticipated required minimum distributions (RMDs), charitable contribution intentions, and estate tax aspects.

Expected future tax rates

A fundamental aspect of a Roth conversion analysis is comparing current tax rates with the expected tax rates applicable to future IRA distributions. Roth conversions may be attractive today for high-income individuals since the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, lowered the top marginal income tax rate. And because the highest marginal tax rate is scheduled to revert to 39.6% from 37% in 2026, or possibly sooner if Congress passes tax legislation, investors who anticipate being subject to these or other higher future tax rates may wish to execute partial Roth conversions that lock in existing tax rates on the conversion of some of their pretax retirement savings.

But even if future tax rates do not increase, a Roth conversion can still be beneficial for a variety of reasons. Here are some other factors to consider when determining if a Roth conversion may be valuable for a particular investor.

Tactical Roth conversions

First, investors ought to look to take advantage of any unique tax attributes they have that may offset or reduce the income tax owed from a Roth conversion. For instance, a large net operating loss or charitable deduction can help alleviate or completely offset the tax from a Roth conversion. If investors find themselves in a temporarily low-income year, a partial Roth conversion can serve to fill up the lower tax brackets. Furthermore, executing a Roth conversion during times of market volatility, when asset values are depressed, can reduce the tax cost associated with the conversion.

Required minimum distributions (RMDs)

Another factor to keep in mind in making a Roth conversion decision is RMDs. Under current law, during the account owner's lifetime, a Roth IRA is not subject to RMDs. Therefore, the Roth IRA can continue to grow tax-free and is not reduced by any RMDs. This is an important difference from a traditional IRA. If the investor's spouse is the beneficiary of the Roth IRA, the spouse may roll over the account as an owner and will also not be subject to RMDs during the spouse's lifetime.

State of residence in retirement

Certain situations involving state residence may argue against converting a traditional IRA to a Roth IRA. Generally, it may not make sense to convert to a Roth IRA and pay state income taxes if the investor anticipates distributing the money later free of state income tax in a different state with no (or lower) state income taxes.

Qualified charitable distributions

For investors who are charitably inclined, another factor to consider is that there is a potential benefit to having a portion of their retirement assets in the form of a traditional IRA. Once investors attain age 70½, they can direct the distribution of up to $100,000 to qualified charities annually directly from the traditional IRA. The distribution is known as a qualified charitable distribution (QCD) and will satisfy part or all of the investor's RMD. QCDs are not included in gross income and therefore may be more valuable than a below-the-line charitable income tax deduction. QCDs may be a tax-efficient way for investors to give to charity by utilizing a traditional IRA.

Estate tax savings

Finally, for some taxpayers, estate tax is another factor to evaluate when making a Roth conversion decision. If investors consider their family as one economic unit, then the income tax dollars expended now to convert to a Roth can be removed from their taxable estate. The Roth conversion leaves heirs with the full balance of the retirement account undiminished by any income tax liability owed upon distribution.

Keep in mind there is no step-up in basis for IRAs, so if investors leave an IRA to their heirs, an embedded income tax liability will be owed at some point. Under the right conditions, paying the income tax on a current Roth conversion results in lower taxes overall by removing the tax dollars from the owner's taxable estate. One can argue that paying the income tax now creates a benefit by removing the tax dollars spent from the taxable estate.

Use of funds outside of IRA to pay conversion tax

Once a decision is made to convert a traditional IRA to a Roth, investors will always want to use outside funds to pay the taxes if they have the liquidity and wherewithal to do so. Paying the conversion tax from outside of the IRA provides a significant financial advantage.

For example, let's assume an investor converted $1,000,000, the effective tax is 37%, or $370,000, and the 10% early withdrawal penalty does not apply to the funds withheld to pay the tax. In addition, let's assume the account will double over the next 10 years (to keep the calculation simple). If taxes are withheld from the IRA for the conversion, there will be $630,000 ($1 million – $370,000) after tax in the IRA and, presumably, $1,260,000 in 10 years. If the tax liability is paid with outside funds, the $1,000,000 IRA will double to $2,000,000 in 10 years.

Since Roth accounts grow tax-free, investors will want to pack as much value as possible into the Roth account by not reducing it for income tax withholding. Furthermore, withholding income taxes at conversion can put the investor in the same position as if the IRA was never converted. Ignoring RMDs, assume the $1,000,000 is never converted and it doubles to $2,000,000 in 10 years. If the IRA funds are then distributed and taxed at the same effective rate in year 10, the investor will be left with the same $1,260,000 ($2,000,000 less 37% tax).

This quick example reinforces that when making a Roth conversion, investors will always want to use outside funds to pay the taxes as it creates a mathematical advantage. For investors under age 59½, another advantage of using outside funds to pay the taxes is that the money withheld from the IRA is a distribution from the IRA subject to the 10% early withdrawal penalty, further lowering the after-tax amount left in the IRA to grow tax free.

Plan cautiously

Besides the factors above, the decision to convert a traditional IRA to a Roth IRA may also reflect subjective preferences, as there are nontax reasons that motivate people to convert. Clearly, too, paying the income tax dollars today has a real cost because deferring that tax would have allowed those tax dollars to remain invested. Investors should plan for any Roth conversions carefully because, under the TCJA, a recharacterization or redo is no longer available. Roth conversions always result in having to pay the income tax on the conversion amount even if the value of the account decreases or the tax burden is more substantial than initially expected.

Robert A. Westley, CPA/PFS, CFP, is a regional wealth adviser at Northern Trust covering the Northeast region. He specializes in the financial management and wealth planning needs of high-net-worth individuals and their families. He is a member of the National CPA Financial Literacy Commission and a former member of the AICPA Personal Financial Specialist Credential Committee. David M. Barral, CPA/PFS, CFP, MST, is a vice president and wealth advisor at Northern Trust in New York City, where he serves as a financial planner to clients. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.

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