Blue Heron CPAs has a clear niche of federal income tax for retirees. The most common planning question we get is around Roth conversions, with many people wondering if, when, and how much should be converted from an IRA to a Roth IRA. The answer isn’t simple and requires a more detailed approach that isn’t commonly provided through general tax preparation services.
This article has been built with the intent of being dense and philosophical. The goal is to develop an understanding of the idea of Roth conversions for people over 59 1/2 years old from a federal planning perspective. Every tax situation is unique; therefore, it is important that you consult a professional who can advise you properly on tax concepts. This article is not meant to be relied upon as tax advice for what you should act on in your personal situation.
Throughout this article, when I refer to the ‘tax and cost’ of recognizing income, I am thinking more broadly than the federal tax bracket alone. The effective cost may include federal or state income taxes and other income-based consequences. In most planning scenarios we see IRMAA, Net Investment Income Tax, Premium Tax Credit, Social Security Taxation, and Capital Gains brackets as important considerations. Some people might refer to this as the effective marginal cost; I just find that term less descriptive.
Is $1 Million in an IRA Really Worth $1 Million?
When you look at your IRA and tax-deferred balance, I often ask clients a simple question.
Would you prefer to have $1,000,000 in an IRA or $1,000,000 in a Roth IRA?
The answer becomes relatively simple for the client for an obvious reason. When a person distributes the value out of the IRA, they will be forced to claim income and that income is likely going to create a tax liability. Whereas, a qualified distribution from a Roth IRA generally is not included in gross income and therefore does not create federal income tax.
This generates an idea that a part of the value of a deferred tax asset such as an IRA or 401(k) is the value at which a taxpayer can realize the distribution net of tax and any other costs associated with the distribution.
Thinking About the After-Tax Value of an IRA
If we assume a 22% effective tax cost when the IRA is ultimately distributed, the estimated after-tax value would be approximately 78% of its nominal balance. In many cases, we see this being around 88% or 78% of the actual value of the deferred asset whether you sit in the 12% or 22% tax bracket. This number becomes nuanced and incorrect as there are other considerations that need to be considered apart from tax brackets which aren’t readily apparent.
One of the interesting results of this understanding is that the realization of income and the tax liability associated with the distribution is partially controllable and therefore can be forecasted over a lifetime based on current tax laws. So, it drives a conversation around a second question.
Would you prefer to have $1,000,000 in an IRA or $800,000 in a Roth IRA?
For purposes of this example, assume the IRA consists entirely of pretax dollars with no nondeductible basis. The answer to that question is heavily dependent on the taxpayer’s situation. If you can realize the $1,000,000 without adding tax and costs greater than $200,000, most would agree they would rather have the IRA. The simple math creates a simple solution whereas the flexibility and maneuverability of a more complex equation ends up with a completely different answer.
If we are to believe that the value of a deferred retirement asset is the net value you retain upon distribution, then a distribution from a taxable asset to an after-tax and non-taxable asset is just a choice in recognizing the cost and taxes in an earlier period which you would recognize at any future period.
A Simple Roth Conversion Thought Experiment
Here is a scenario that describes it. Let’s assume a 20% effective cost in all years for easy math and understanding:
| IRA | IRA Distribution | New Roth Balance | Tax and Cost (Withheld) | |
| Year 1 – Start | $1,000,000 | $0 | $0 | $0 |
| Year 1 - Event | $1,000,000 | $160,000/$40,000 | $160,000 | $40,000 |
| Year 1 - End | $800,000 | 0 | $160,000 |
With this assumption, we would have evaluated the IRA at 80% of its nominal value as the cost and tax of distribution and realizing the asset reduces the nominal value by 20%.
In Year 1, we started with $1,000,000 of IRA value which, if we assume the 20% effective tax and cost on distribution, would be worth $800,000. During the year, we distributed $200,000 from the IRA which consisted of a conversion of $160,000 to Roth and recognizing $40,000 of tax and cost as withholding from the transaction. At the end of year 1, we would still assume a 20% effective cost and tax of distribution of the $800,000 in remaining IRA assets which means we have $640,000 in IRA value. We have spent and realized $40,000 in tax and costs, and we have a $160,000 Roth IRA asset which has no effective cost and tax on it upon distribution assuming future distributions are qualified. This develops an understanding that we still hold $800,000 in estimated after-tax value when we add our IRA and Roth IRA value together.
Keep in mind, this is an extreme vacuum scenario that has many other variables removed and is theoretical. In your life, it is almost never a clean analysis. The choice to pay tax and cost through the conversion itself versus outside of the conversion is a choice in itself which is also a variable you must solve for. By looking at this within a vacuum though, we can see that the movement of money from a deferred tax asset to an after-tax Roth account has no true effect on wealth so long as the effective cost and tax of a distribution remains the same for each year and all income. This now becomes what we need to analyze and solve for.
The Real Roth Conversion Question: Tax Now or Tax Later?
Due to the fact that the tax rate will change based on changing tax brackets, changing tax laws, changes within the stock market, and changes within the taxpayer’s life, we must now make decisions based on opportunities to realize cost and tax that are lower than what future realized cost and tax might be. By recognizing income ranges which hold a consistent cost and tax over an income range, though creating additional tax in the more present years, it reduces the risk that higher cost and tax years will be forcefully recognized. This is the fundamental idea behind Roth conversions.
So, the next question we ask taxpayers:
If you are willing to pay 25% cost and tax on a portion of your income, why are you not willing to pay 22% or even 24% to mitigate the exposure to 25% in future years?
From our experience, the taxpayer hasn’t been asked this question and has never thought about it in that way. Here is another question that shortly follows:
What if paying more today would create flexibility in your options and would potentially save you future tax over the rest of your lifetime?
This isn’t how most taxpayers are taught to think. As a society, we have been taught that we should seek to reduce our tax liability every year, not thinking about the lifetime impact of that decision. At a young age, paying taxes at lower costs early in life could save significant tax and cost as you’re paying higher tax and costs on income realized in future years. The growth would compound as well, leading to situations where a $5,000 amount of cost and tax paid in Year 1 could save you $20,000 to $30,000 of cost and tax expected at Year 16.
The nominal amount of future tax avoided can become much larger as the account compounds, but that does not by itself mean the conversion created equivalent economic savings. The tax and cost paid within Year 1 also has an opportunity cost that must be evaluated.
This leads to a question:
Are you paying less cost and tax as a percent of income today compared to what you think you will pay in cost and tax as a percent of income later in life?
If the answer is yes, which for most people we find to be optimistic about their own life, it would lead us towards taking the tax hit today in hopes of reducing the cost and tax owed at a future date.
Four Principles for Evaluating a Roth Conversion
The Roth itself does not magically create wealth. The planning opportunity comes from differences between the economic cost of recognizing income today and the expected economic cost of recognizing that income later.
I realize I am belaboring a point that is theoretical and requires a crystal ball approach to think about. The big points here are:
- Recognition of income and paying tax in the current year may increase the realizable net worth after tax even though the nominal value might be smaller.
- Recognition of income and paying tax in the current year may increase the realizable value of what you would expect in the future.
- Estimating the tax and cost of recognizing income today versus later helps determine how much wealth you may want held in tax-deferred versus Roth accounts.
- Recognizing tax at lower rates in an accelerated way can mitigate higher exposure in future years.
I hope this article helps organize your thought process and generates additional questions that are more direct and thoughtful. A Roth conversion is almost never a small decision, and it should always be approached with appropriate guidance from a qualified professional. It isn’t always a given that you should be converting to Roth, but the lack of understanding when it is optimal can create a large tax exposure later in life.
Disclaimer:
This article is for educational purposes only and should not be treated as personalized tax, investment, legal, or financial advice. The article is written from the perspective of a Florida individual and other states may have different laws. This article has not been updated since the date of writing. Links are provided to easily confirm where the information came from. Use it to help you ask better questions about your situation. For advice tailored to you, consult a qualified tax professional.
Author
Nathan Gauger is the Managing Partner of Blue Heron CPAs and focuses on retirement tax planning—helping retirees make confident decisions around Roth conversions, RMDs, Social Security timing, and Medicare-related costs like IRMAA. His goal is simple: make sure your tax plan supports the life you want in retirement, not just the return you file this year.
Ready to talk? If you’d like help reviewing your tax situation or building a retirement-focused plan, the simplest next step is to Schedule a Discovery Call.