Roth IRA Conversions: Benefits and Factors Beyond Taxes

A notebook sits on a desk with the words Roth IRA conversation written on the top page.

(Image credit: Getty Images)

By Troy Sharpe, Certified Financial Planner

published 29 September 2023

Roth conversions have emerged as a prominent strategy in retirement planning, primarily due to the potential for tax-free growth and income. When deliberating on Roth conversions, it is crucial to consider several factors that extend beyond mere mathematical calculations. These factors encompass indirect but significant benefits.

Essentially, a Roth conversion entails transferring funds from traditional retirement accounts, which are subject to taxation upon withdrawal, to Roth IRAs. This strategic maneuver is aimed at eliminating future tax-related risks, reducing the overall tax burden over time and increasing the value of one's after-tax retirement savings.

With respect to tax considerations, numerous elements, such as age, projected life-span, spending objectives and the composition of existing accounts, should all be considered. The composition of accounts refers to the ratio of funds held in qualified retirement accounts vs non-qualified accounts, like taxable brokerages or savings accounts.

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In an ideal scenario, it is advisable to satisfy the tax obligations using funds from taxable savings or investment accounts instead of utilizing withholding from the IRA. This approach is recommended since the distribution from the IRA employed for tax payment is also subject to taxation, which ultimately makes the conversion a more expensive endeavor. Minimizing this "extra tax" is typically achieved by paying taxes from taxable accounts, thereby maximizing cost efficiency.

What you pay in taxes no longer contributes to nest egg’s growth

Another aspect that warrants consideration is the opportunity cost associated with the loss of potential future interest on the funds directed toward tax payment to the IRS. By using said funds to satisfy the tax obligation, these resources are no longer available within the retirement account to grow over time.

Regardless of the chosen course of action, it is important to acknowledge that executing a Roth conversion will inevitably result in a decrease in the total net worth, as this process entails the payment of taxes on the transferred amount from the IRA to the Roth IRA. Thorough modeling exercises should be conducted to understand the overall value of the conversion to determine the point at which the benefits outweigh the costs.

Traditionally, the calculus of whether to convert or not has been a function of what rate you will pay today compared to an estimated future rate when you have to withdraw. If the rate is lower today, it makes sense to convert. While this basic method isn’t horrible, it leaves out many indirect (and direct) considerations.

To determine the proper conversion strategy, you should look at the total value of retirement, which is the sum of your cumulative spending and ending account balances, in a comparative format.

Consider higher tax rates in the future

In addition to the aforementioned considerations, it is important to recognize the potential for higher taxes in the future. Right now, in 2023, a married couple can have a taxable income of $364,200 and remain within the 24% tax bracket. However, in the absence of congressional intervention, the Tax Cuts and Jobs Act will sunset at the end of 2025, resulting in a reversion to the 2017 rates and brackets. Under this scenario, a married couple's taxable income above $153,100 (not adjusted for inflation) will be subjected to a 28% tax. This means that withdrawing or converting more than $200,000 can be done at a lower rate compared to in 2026.

Further, it is important to consider the implications of single brackets. Should one spouse pass away, the surviving spouse would transition into single tax brackets in the year following the first spouse's death. The 2017 tax brackets impose a 28% rate once income surpasses $91,900 for single filers. Possessing funds in a Roth IRA can help mitigate the substantial reduction in tax brackets associated with this transition.

Neglecting to comprehend the potential magnitude of required minimum distributions (RMDs) represents a significant oversight in retirement income and tax planning. RMDs begin at about 4% and increase annually. These distributions are fully taxable and, when combined with other sources of income, can trigger additional taxes, such as the net investment income tax (NIIT) and Medicare Parts B and D income-related monthly adjustment amounts (IRMAA). By contrast, Roth IRAs are not subject to RMDs, enabling individuals to maintain a potentially lower taxable income in future years.

What would a conversion mean for your heirs’ tax burden?

Legacy planning also merits consideration in the context of Roth conversions. The SECURE Act stipulates that children must fully distribute their parents' retirement account balance within 10 years of the last surviving spouse's death. This distribution is added to the children's existing income and has the potential to subject the retirement account to full taxation at or near the highest tax rate. In states with income taxes, it is reasonable to expect that 40% to 60% of the total account balance could be owed to the government. With the Roth IRA, those proceeds still have to be distributed after 10 years but all gains during that time, along with principal, will be tax-free.

Furthermore, it is noteworthy that distributions from Roth IRAs do not impact modified adjusted gross income (MAGI). This exclusion from the MAGI formula can confer substantial benefits, including the reduction or elimination of taxes on Social Security income as well as the avoidance of Medicare surcharges. For example, according to current law, a joint filing by both spouses age 65 or older with $80,000 in Social Security income and a $50,000 Roth distribution would owe $0 in taxes.

If the $50,000 were instead an IRA distribution, up to 85% of their Social Security would be taxable as well as the entire IRA distribution, leading to about $7,822 in federal income taxes.

Keeping more of your Social Security, paying less tax over time and being in control of when and how much tax you pay are valuable benefits that could contribute to your decision to convert your IRA dollars to tax-free Roth accounts.

Kim Franke-Folstad contributed to this article.

The appearances in Kiplinger were obtained through a public relations program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Troy Sharpe is the founder and CEO of Texas-based Oak Harvest Financial Group. In 2023, Investopedia named Troy a top 100 adviser in the country. He holds a Series 65 license as well as a Texas life insurance license. Troy earned his bachelor’s degree in finance from Florida State University and completed his Certified Financial Planning certification at Rice University. He completed his Certified Private Wealth Advisor coursework through the Yale School of Management.