Cutting Taxes By Converting To A Roth: An Analysis (2024)

(This article was co-produced with Hoya Capital Real Estate)

Introduction

When I retired in 2019 and before starting Social Security in late 2021, I found myself with space to play within my current tax bracket and the lowest income level where our Medicare premiums would jump almost 50%. One downside of saving taxes by using the Pre-tax option on my 401k plan, is now I face an RMD in 2027 (hopefully delayed to 2030 if SECURE Act 2.0 passes as proposed), that will push me up one bracket and into the first level of IRMAA premium boosts. When it became available late in my career, I reduced that bubble by funding the Roth version instead.

Since there is a maximum contribution level into a 401k account, I also used the higher limit that allowed for After-tax contributions. My plan is to convert most of my 401k into IRAs before the RMDs start, mostly to avoid RMD at all for the Roth 401k assets I also have. By year-end, I will have simplified that rollover by converting all my After-tax 401k funds into the Roth 401k option. Making life easier later meant paying taxes now on the growth and matching funds that made up about 40% of the After-tax funds.

This article was prompted by my wanting to see if it made sense to start converting the 100% taxable Pre-tax part of my 401k account. What I found was there is a small chance I will be better off and a good chance my beneficiaries could be.

Conversion Analysis

This is based on where I am and what I might do. That said, the tests run should apply to most situations. The attached spreadsheet is easy to adjust. Here are the inputs I adjusted for the various tests.

• Annual ROI: I assume regardless of where the funds were, they would earn the same return.
• Current tax: Investor's current marginal tax rate, which was assumed to stay unchanged until the RMDs started.
• Estimated tax: Investor's marginal rate once RMDs started. A pessimist would assume the 2017 rates return after 2025. Consider adding your state income tax to both rates.
• IRA balance: Combined total of IRAs and/or taxable 401k balances.
• Converted: Amount of possible conversions, possibly yearly until RMDs start. One could convert post-RMD but most likely at a higher tax rate.
• IRMAA: Reflects 2022 Medicare Parts B & D increases if investor's MAGI breaks the lowest income threshold, currently about $180k for a couple. The amount assumes the investor has a spouse, otherwise use half shown.
• Inherit tax: Tests assume my beneficiaries pay lower taxes and would empty the IRA in the first year, not over the ten allowed.

The first run used the above assumptions, as these best match my current expectations. This table shows results without conversions. I think the Column headings are self-explanatory.

The Grand Total equals the ending values of IRA and Accumulated RMDs. This is how it changes with $300,000 converted into a Roth IRA.

Using the above set of inputs, not converting was slightly better. That advantage disappears if the change in RMDs, which is small, is enough to always avoid the IRMAA boost, then converting becomes the better option when this investor turns 90. Even with the Inheritance assumption, the breakeven age only drops to 87.

This is the summary version in a side-by-side.

“w IRMAA” is breakeven with Medicare premium penalties included. “IRMAA” is the cumulative amount, which under-represents what might happen as the penalty grows faster than the base rate. The last two columns reflect the balance after the IRA balance is liquidated and the tax paid. While these values will change as inputs change, here are some observations:

• While the breakeven age is way down the road, the largest deficit was 7.5% of the starting balance, and 79, it was down to 5%.
• From a beneficiary’s view, the longer they wait, the bigger payoff from converting.
• The RMD is highly correlated to the percent converted, as one would expect. So even by converting 30% of the balance, the largest reduction only amounted to $27k, under 3% of the starting balance.
• The difference is the RMD is very small and thus unlikely make a difference in whether the investors pay the IRMAA penalty.

Sensitivity analysis

As I said, I ran various scenarios to see how changing the inputs moved the breakeven age. Here are those observations:

• Future Tax rate: B/E Age only drops to 89 at 31% and 87 at 34%. If you are wrong and your tax rate doesn't increase, the difference in value is 6.2% at 72 and decreases down under 1% at 92, using the initial assumptions.
• Current Tax rate: B/E age is still 85 if the investor's current marginal rate is only 15% and goes up to 28%.
• Earnings: While the investor does better without conversions as their ROI increases, the beneficiaries do better if the investor converted.
• Timing: There is a slight advantage to doing the conversions as close to when the RMDs start. This becomes more pronounced as your ROI increases.
• Beneficiaries: Adjusting any of the inputs does not move the age and the advantage of not converting but it is small regardless of the age of the investor when they die.
• Extremes: Setting the inputs to 12% ROI, taxes to 15%/34%/10% only drops conversion B/E age to 82 but by 92, the value difference is about $900k in favor of converting.

Portfolio Strategy

So if a conversion strategy does not appear to generate a big difference in tax liability and it is years to the breakeven age, investors need other investment strategies to achieve lower income taxes without losing any or little income.

• Place high-yielding assets in your Roth account and lower-yielding assets in your other accounts. Though eventual taxes could be higher, placing income assets in IRAs versus a taxable account delays taxes until RMDs start.
• Consider the concept of buying no/low dividend growth stocks and selling shares when income is needed.
• Find income-generating assets whose payouts are mostly long-term gains or return-of-capital. Buy/Write funds are an example investment.
• After contributing enough to earn any employer matching funds, start funding your (and spouse’s) Roth IRA, especially early in your career when your tax rate should be lower than in retirement. If you did less Pre-tax to do this, while the breakeven is years away, the tax benefit could be large.
• After reaching 70.5, consider reducing any IRA by starting QCDs. After RMDs start, use QCDs instead. This might also allow you to switch to using the Standard Deduction if charitable giving comprised a large part of your itemizations. QCDs instead of RMDs given to charities doesn’t effect taxable income taxes but keep that activity from effecting IRMAA. Read this article for more on this concept.
• Finally, if income is not a concern, consider helping to fund the next generation's retirements by contributing to their Roth IRAs, even if it means getting one started.

For another take on the subject, I found this Seeking Alpha article: How To Analyze Roth IRA Conversions

Conversion.xlsx If you find a calculation error, use PM to discuss and I will update the article.

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