Tricky Conversion Math

A Roth conversion is the process of moving (pre-tax) money out of a traditional IRA into a Roth account.  You pay taxes on the amount of the exchange, in return for never having that money taxed again, either as the Roth account grows or when you take the money out in retirement.

But the mathematics around these conversions can be a bit tricky.  Is it better to pay taxes now vs. when the money comes out?  The traditional (and rather simplistic) rule of thumb has been: if your tax rate in the future will be higher than it is today, then this move will save you money.  If not, then it will cost you money.  If the rates are the same, then the Roth conversion will be an essentially neutral transaction, from a tax standpoint.

So why is this tricky?  Because there are a number of other factors to consider.  First of all, you are paying taxes today in return for a tax break in the future.  If you put the money you would not have paid in taxes into a side account, what rate of return would it generate?  This, of course, is unknown, but so too are future tax rates.

A recent study looked at various factors, and found that the number of years between the conversion and the time when the money comes out can play a role in whether the Roth conversion is a winning or losing strategy.  Calculating the advantage based on this holding period, alas, is also complicated because we cannot predict the future rate of return or the future tax rate with any degree of confidence.  Another impact the article looks at is the tax cost of liquidating other parts of the portfolio to pay those taxes on the Roth conversion.

There are a few additional complications.  One often-overlooked issue is that reducing future tax rates with a Roth conversion will also reduce the IRMAA surcharge that the retiree would have to pay on Medicare premiums.  Lower future income might also mean a lower long-term capital gains rate on holdings in a traditional (taxable) retirement account, from 20% for high income earners to 15% for people in lower brackets.  Those future bracket thresholds are also unknown.

If people have large tax loss carryforwards or are experiencing a year when their income is low, then that creates an opportunity to convert IRA to Roth assets at lower rates, upping the odds of successful tax arbitrage.  The article in question suggests that, all things considered, most Roth conversions can be expected to reduce total taxes within the joint life expectancy of a typical married couple, so long as the conversion is carefully planned with the input of a professional advisor.  

Source:

https://www.financialplanningassociation.org/learning/publications/journal/MAY23-arithmetic-roth-conversions-OPEN