Last month we shared four smart planning moves investors should consider right now. One of them, Roth IRA conversions, drew a lot of interest. So we wanted to follow up that post with a more detailed example of what goes into a Roth IRA conversion and if it makes sense for you. We’ll also discuss the mechanics of “clean” back-door Roth conversion as there seems to be a bit of confusion on this topic.
What is an IRA to Roth conversion?
An IRA to Roth conversion is when you take assets held in a traditional IRA account and convert them to assets in a Roth IRA. This conversion typically takes place through paperwork with your broker and they handle the transfer. You shouldn’t simply initiate a transfer from your IRA to your Roth IRA without first talking to your broker about the proper steps to take.
In most cases, and for the purpose of this example, Roth IRA conversions will trigger additional income taxes. For example, a married couple with $250,000 in taxable income paid roughly $42,000 in federal taxes in 2021, for an effective federal tax rate of about 17%. If the husband converted $50,000 worth of Traditional IRA assets to a Roth IRA in 2021, that would have added $50,000 in income to the household’s income. Therefore, their new taxable income would be $300,000 which would trigger $54,000 in federal taxes for an effective federal tax rate of about 18%.
This is $12,000 more in federal taxes owed as a result of the conversion. The money for these additional taxes should not come out of the amount you’re converting. In other words, if you’re doing a $50,000 conversion, put all $50,000 into the Roth IRA. Do not leave $12,000 out for taxes (and only put in $38,000). If you do this, the $12,000 will be treated as a withdrawal and may be subject to a 10% penalty (for an additional $1,200 in taxes owed). As a rule, always pay the taxes triggered by Roth IRA conversions with funds that are totally separate from the conversion.
The math behind a Roth conversion
By taking the amount of tax a Roth IRA conversion will trigger, we can formulate what type of return we need in the market to earn those taxes back. In our example above, the $50,000 conversion triggers $12,000 in additional taxes owed. This is equal to 24% of the $50,000 conversion amount. So you need to earn a 24% return on your $50,000 conversion to earn back the cost of your tax bill. Above that and the conversion becomes profitable, after taxes.
It is easier for the market to achieve a greater return from a lower starting point. This is why, with the stock market and bond market down around 20% and 12% on the year, respectively, we are recommending clients consider Roth IRA conversions now… the math makes more sense than it did when the market was at its high. Our example needs a 24% return to earn back the cost of their taxes. This breaks down to needing a 7.43%, 4.40%, or 2.17% annualized return over the next 3, 5, or 10 years.
The tax bracket effect of Roth IRA conversions
One of the things to be most mindful of when considering a Roth IRA conversion is your tax bracket. More specifically, where will a potential Roth IRA conversion be taxed. There is a big jump in the US tax brackets that occurs in the middle of the bracket, where you go from being taxed at 24% to 32%.
Recall our example, a married couple with $250,000 in taxable income that then does a $50,000 conversion… that means 100% of the $50,000 conversion is being taxed at the 24% rate (since it falls between $172,751-$329,850). If this couple wanted to do a $100,000 conversion they would be taking their taxable income up to $350,000. This would mean that $79,850 of their $100,000 conversion would be taxed at 24%, but then $20,150 would be taxed at 32% (since it bumps them to the next bracket of $329,851-$418,850).
So now the taxes owed from the conversion is $25,612 (($79,850 * 24%) + ($20,150 * 32%)). Put another way, the $100,000 conversion is taxed at an effective rate of 25.612% versus the 24% that the $50,000 conversion was taxed at in our first example. This isn’t a big difference, but it still changes the rate of return needed to earn back the cost of the taxes to 7.90%, 4.67%, or 2.31%. These numbers are roughly 6% higher than the returns needed on a $50,000 conversion.
If this were a real life example, we might advise the client to convert the highest amount that still leaves them paying 24% on the conversion, as to avoid going into the 32% bracket with any taxes owed. For our made-up $250,000 married couple, that amount would be $79,850.
What about a ‘back door’ Roth conversion?
We looked at an example of converting Traditional IRA assets to a Roth IRA account, which will typically always trigger additional income taxes. However, there is a conversion you can do that doesn’t trigger any taxes, referred to as a ‘back-door’ conversion.
This involves making a non-deductible contribution to a Traditional IRA account, and then converting those assets to a Roth IRA. This, however, should really only be done if you have no existing Traditional IRA assets. Otherwise, if you have existing traditional IRA assets and try to do this type of non-deductible contribution/conversion trick, the IRS will flag your conversion using the IRA aggregation rule. This rule will likely leave you with some surprise taxes. So again, the cleanest way to do a back-door conversion is if you have no existing traditional IRA assets.
Anytime you make a non-deductible IRA contribution you should log it on a Form 8606 come tax time. This form will help you keep track of non-deductible contributions and serves as your record with the IRS that any such contributions that then ended up in a Roth IRA are allowed to be there. Just as with our earlier conversion example, you should apprise your broker of your intentions with the non-deductible contribution and back-door conversion. That way you can be sure that any necessary paperwork gets handled properly and you’re not susceptible to unexpected taxes.
When to consider these conversions
One of the main reasons Roth IRA conversions are a worthy consideration right now is due to the decline in the market. A market weighted IRA account has likely lost between 15%-20% in value this year. Therefore, the taxes triggered by such a conversion are less than they were six months ago. In addition, the market’s current potential low price point may mean you earn back the cost of your conversion faster.
If you’re someone who views your retirement assets not just as your own, but also as your heirs, then you’re doing them a big favor by getting more money into a Roth IRA now. Roth IRAs are inherited tax free, while traditional IRA assets are not. If person A inherits $1 million of a Roth IRA and person B inherits $1 million of a traditional IRA, person B will likely end up with less than $800,000 after taxes. Person A will see the full $1 million.
There is no blanket answer for if you should do a Roth conversion, it all depends on your personal financial situation and desires. But if you do a conversion, make sure you understand the math and speak to your tax professional or financial advisor. That way you’ll understand what your tax bill may look like and have a better ability to weigh the pros and cons of a Roth IRA conversion.
Don’t want to miss anything?
Subscribe to our monthly newsletter for market insights.