Is the Time Right for Roth Conversions?

On The Long View podcast is Tim Steffen, director of tax planning for Baird, discussing retirement, Roth IRA conversions, and challenges that retirees face in today’s market.

Here are a few excerpts from Steffen’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Benefits of IRAs and the Danger of Conversions

Ptak: Wanted to switch gears and talk about IRA conversions. We’ve also been hearing more about converting traditional IRA balances to Roth in this year’s down market. Before we get into why this could be an opportune time to consider converting, can you discuss the cheap benefits of Roth IRAs and why a conversion might be advantageous in some situations?

Steffen: The two broad categories of IRAs, you’ve got traditional and Roth, and they are almost mirror images of each other. The traditional IRA, you put money into that account, you generally get a deduction today for whatever you put in. So, you get a tax savings today. While the money is in the account, it grows on a tax-deferred basis. No tax on any of that growth. And then, when you take the money out later in life during retirement, you pay tax on everything you take out. The Roth is kind of the exact opposite of that. You put money into the Roth, there’s no tax issues, no tax benefit for putting anything in there today. It’s all considered aftertax money. It grows on the same tax-deferred basis. But when it comes out, it’s completely tax-free. That’s the general difference between the two. IRA is deductible going in, taxable coming out, or traditional; Roth IRAs, nondeductible going in, nontaxable coming out.

The other big difference between the two is, when you get into retirement, with a traditional IRA, you’re required to begin taking money out of that once you turn age 72. With a Roth, no such required minimum distributions. You can put money into a Roth and leave it in there for the rest of your life, the rest of your spouse’s life. And under the latest rules, for the first 10 years after your death, in most cases, depending on who your beneficiary is, another 10 years of tax-free growth.

Now, the other way that people fund Roths, other than just the annual contributions, would be this conversion that you referred to. And that’s where you’re making a conscious decision to say I’m going to take some money that’s in this traditional IRA account that is growing tax-deferred, I’m going to take it out, I’m going to pay tax on it. I’m going to move it to this other account, this Roth, and I’m going to let it grow tax-free from that point forward. So, I made a decision that instead of letting the money stay in the traditional and grow tax-deferred for as long as I can, I’m going to take it out now and pay the tax, and then let it grow tax-free from there. I’m accelerating a tax. I’m paying a tax I don’t have today. But in return, I want to get that tax-free growth.

Done correctly—if you meet a few of the general tests that we try to apply to conversions—it could be a very powerful planning tool. It’s not always done correctly. Sometimes people do these conversions and then make some of the cardinal mistakes that we talk about with conversions. But in general, if it’s done right, a Roth conversion, can be a very positive and very powerful planning tool.

No RMDs and No Tax on Qualified Withdrawals

Benz: You just mentioned no required minimum distributions and no taxes on qualified withdrawals as the chief advantages of Roth IRAs. One question that sometimes comes up when you talk about those benefits is whether Congress could change the rules related to Roth withdrawals, start taxing the withdrawals of investment earnings, for example, or maybe imposing required minimum distributions to bring Roth IRAs in line with traditional IRAs. How likely would changes on that front be, in your mind?

Steffen: Being a little Pollyannaish when I think about these, I just don’t see Congress ever turning earnings in a Roth IRA into taxable income. I don’t think they’re going to do a bait-and-switch on people like that. Maybe I’m wrong. Maybe I’m being too positive on the outlook there. I know a lot of people might disagree with that. But I just don’t see that happening. I think there’s a lot of things they could do to cap these benefits. We saw a little bit of that with the new 10-year rule, where maybe they start imposing required minimum distributions on Roth IRAs, not just after your death, but even during your own lifetime. I could see that start to happen. I could see them maybe limiting your ability to put money in there. We saw some of that with the Build Back Better bill, that was all the rage late 2021 into early 2022 that ended up not going anywhere, where they were going to perhaps limit the ability to do Roth conversions and some of the other things that are out there. But again, in the list of things that concern me about future tax law, turning Roth accounts or taxing income from a Roth, I’m not overly concerned about that one, to be honest.

Tax Implications of Conversions

Ptak: Let’s talk about the tax implications of conversions. What should people think through before undertaking a conversion, the pros and the cons?

Steffen: Again, every dollar you take out, for the most part, from a traditional IRA and then convert to a Roth is going to be considered taxable income. There are some exceptions there, if you’ve got some aftertax funds in the traditional, which you can talk about. But in general, when you take money out of the traditional, move it to the Roth, it’s going to be taxable income. And you could do that at any age. Normally, if you take money out of a traditional IRA before age 59.5, you get hit with a 10% early withdrawal penalty. That’s not the case if you do a conversion. There’s an exception to the penalty for those kinds of cases. So, you can just roll it from one account to the other, you got to pay tax on.

It’s going to be ordinary income, taxable at whatever your normal ordinary tax bracket would be—based on your other income, your wages, your other retirement distributions, Social Security, whatever it might be. A couple of things we always tell people to be cautious of when you do these conversions. One is, we try to make sure you pay the taxes on the conversion from dollars outside the traditional IRA. Often, we’ll see people do a Roth conversion, and they’ll say, can you just withhold from the money that comes out to pay the taxes on it, so I don’t have to write a check for the tax liability? And what we often see is that if you run the numbers on it, if you pay tax on X, but you only put Y into the Roth and the rest goes to the IRS, it’s really hard to make up for the fact that you’ve accelerated that tax liability. The real power of the Roth comes from getting as much into the Roth as possible and then using other dollars to pay the taxes. That’s one thing we try to get people to avoid is to not pay the taxes from the IRA dollars themselves.

That’s especially true for somebody who is under 59.5 and doing a conversion. If you do a Roth conversion under 59.5, and let’s say, you take money out of the traditional, but some of it goes to the IRS in the form of withholding, well, those dollars are not exempt from the penalty. If you take out $100,000, you withhold 20% to go to the IRS, that $20,000 would be penalized in that case at the 10% early withdrawal penalty. So, we really try to avoid people using the IRA dollars to pay the taxes on it.

The other big thing that we try to encourage people on is that once it’s in the Roth, you really want to let it stay in the Roth for as long as you possibly can. The biggest mistake we see with Roth conversions is people do the conversion and then decide, “You know what, I need some extra money this year, I can pull that out, I don’t have to pay taxes on it, because I’ve already paid the tax, which is true.” But now, you’ve given up the tax-free growth you were getting on that. So, Roth conversions really work well if you can let the money stay there for as long as possible. And in fact, the best dollars to convert are IRA dollars you don’t think you’re ever going to need. Your spending goals are modest. Your resources are large relative to your goals. You just got money there you’re not going to need. So, you can convert those, leave it to your heirs. Consider the taxes you pay a gift to your heirs. That’s really the best strategy we’ve seen from Roth conversions. It doesn’t happen all that often, because people are concerned about writing that big check for the Roth conversion. But to me, that’s the ideal scenario for a Roth.

Should You Consider Conversions in Today’s Down Market?

Benz: This year’s down market may provide an opportune time for some people to consider conversions, but life stage, I think, can also figure in here. And we sometimes hear about the postretirement, prerequired minimum distribution years as a really good time to consider conversions. Can you talk about that? What about that particular season of life might make conversions worth considering?

Steffen: One of the tests that people use to determine should I convert or should I not is what is the tax bill I’ll pay to do the conversion versus what is the tax bill I would pay in the future if I just took the money out of my traditional IRA. And generally, if you can do the conversion when you’re in a lower tax bracket than when you would maybe take the money out of the account, that’s an ideal scenario. It doesn’t have to be that way. We can show examples where you can even pay a really high tax on your conversion and still have it work out right, even though you might be in a lower tax bracket in the future.

What you’re referring to, Christine, I often call it the tax trough, that period of time between when you’ve stopped working, so your W-2 income has gone away, and before you started Social Security, your RMDs haven’t kicked in—typically, we’re looking at mid- to late-60s time period for most people, when you’ve got more control over what your taxable income is on an annual basis. Take advantage of the fact that you’re artificially in a low tax bracket. And if you could take money out of the IRA at a low rate and then put it into the Roth where it grows tax-free, that’s really the ideal time to do the conversion. Again, take advantage of any period when you’re in an artificially low tax bracket, something that’s not going to last forever—typically, that’s that period between retirement and starting RMDs, but it might also happen, say, for a business owner who maybe generates or has a loss from their business one year. So, their taxable income is way down. Maybe that’s a year to take advantage of being in a low bracket and do a Roth conversion, too. You can apply not just at retirement, but even during your working years as well if the right scenario pops up.