Last week, my ten-year-old son and I had a chance encounter with the commissioner of the Boston Police Department. After saying hello, he bent down and offered my son this advice: “Stay in school,” he said, “and listen to your parents.”
Oftentimes, the recipe for success is just that simple. When it comes to managing your finances, the basic principles are equally straightforward. But there is one topic that often leaves people with a headache. That’s the question of whether, or when, to do a Roth conversion. At the risk of giving you a headache, I’d like to tackle that question today.
If you’re not familiar with it, the idea behind a Roth conversion is that individuals can choose, at any time, and at any income level, to move money out of a traditional IRA and into a Roth IRA. There is a catch, however: In the year that you do a conversion, you must pay income tax on the amount that you convert. So, the bet you are making is that your tax rate today will be lower than it will be later on, when you otherwise would start taking money out of your IRA. Answering that question, however, involves several unknowns. Not only do you have to estimate your future income, but you also need to guess whether Congress might change the tax rates again. And, if you think your children might ultimately inherit your IRA, you’ll need to factor in their tax situation. Worse yet, as of this year, Congress took away taxpayers’ ability to “recharacterize,” or undo, a conversion, so you really want to be confident in your decision before you go ahead with a conversion.
Absent a crystal ball, there is no foolproof way to make this decision, but these are the steps I would recommend:
Step 1: Determine your current marginal tax rate. (The term “marginal” refers to the rate on the last dollar that you earn.) Typically, this isn’t difficult. But, because new rules went into effect in January of this year, I suggest asking your accountant for help.
Step 2: Try to estimate, however roughly, what your income will look like in retirement. Conventional wisdom says that your income, and therefore your tax rate, will always be lower in retirement than while you’re working, but you’ll want to test this assumption rigorously. The following formula is a starting point for estimating your taxable income in retirement:
Social Security income
Plus: Required minimum distributions from your IRAs
Minus: Qualified charitable distributions from your IRAs
Plus: 3% of the value of your taxable investments (allowing for dividends and interest)
Plus: Pension or annuity income
Plus: Income from part-time work, rental properties or other passive income
Minus: Standard deduction
Equals: Estimated taxable income in retirement
Now, compare your current tax rate to the rate that would apply in retirement. If you’re confident that your future tax rate will be demonstrably higher than it is today, then you might consider doing a conversion now. Otherwise, I would wait.
Step 3: If you’re currently in the highest bracket, or if a Roth conversion would put you in the highest bracket, then you probably won’t want to do a conversion. There are, however, two exceptions to consider:
Exception #1: If you believe Congress will raise rates in the future, then it’s possible that your tax rate could be even higher down the road. (It may seem hard to imagine, but as recently as 1981, the top tax bracket was 70%.) I wouldn’t base a decision on this kind of speculation, but some people feel strongly that our fiscal situation will require higher tax rates in the future, so it’s something to consider.
Exception #2: If your assets are likely to make you subject to the estate tax (approximately $22 million for a married couple), then it might make sense to do a Roth conversion during your lifetime, even if you are in the highest tax bracket. That’s because the income taxes you would pay to do the conversion would reduce the size of your estate, and thus reduce your estate tax bill, but would not reduce the after-tax value to your children.
Step 4: Be sure you can afford it. Unless you are older than 59 1/2 years old when you do a Roth conversion, you’ll need additional funds to pay the associated tax. You won’t be able to take it out of your IRA without penalty.
Step 5: If the calculations you do in Steps 2 and 3 don’t favor a Roth conversion today, that doesn’t mean it will never make sense. For planning purposes, it’s worth forecasting when the math might work out. For most people, there is a brief time window, just after you stop working but before age 70, when your income may be low enough to accommodate a conversion. To evaluate this, I suggest using the same formula from above to estimate your tax rate during those early retirement years. If you do foresee a period of low-tax years, you may want to mark your calendar and plan for a series of conversions during those years.
As you can see, the Roth conversion question isn’t easy. For that reason, my overall recommendation is this: After working through these steps, I wouldn’t do a conversion unless the numbers clearly and conclusively favored it. If the math is at all inconclusive, I would wait and revisit the question each year in the future.