When Is a Roth Conversion Best?

Note: This video is one of several interviews that Morningstar director of personal finance Christine Benz had with Vanguard officials at this year's Bogleheads event. See all of the interviews here.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Many investors are attracted to the idea of tax-free IRA withdrawals in retirement, but they struggle with whether it makes sense to convert traditional IRA assets to Roth. Joining me to share some guidance on that topic is Joel Dickson. He is Vanguard's global head of advice methodology.

Joel, thank you so much for being here.

Joel Dickson: Great being here, Christine. Thank you.

Benz: Joel, let's discuss the benefits of converting traditional IRA assets to Roth. Why would someone want to do that in the first place?

Dickson: The traditional IRA and the Roth IRA are kind of like opposite sides of the same coin. In one case, the traditional IRA, you pay taxes when you take the money out. With the Roth IRA, you pay taxes when you put the money in effectively, assuming you meet the other rules for IRA withdrawals and contributions. And so, you as an investor may have different tax situations over the course of your life: higher tax rate, lower tax rate, different things that might affect it. This decision of whether you should have traditional assets or Roth assets or the mix between the two is, in many ways, dependent on your own personal situation and your being able to assess that situation could lead to one or the other.

Benz: I want to talk about a framework that you have written about to assess that decision. But let's talk about required minimum distributions before we leave the conversion question because that's another thing in the mix, that with the Roth IRAs you are not subject to RMDs, right?

Dickson: Yeah. There are a lot of nuances around just, hey, do I have money in a Roth IRA. There are interactions with other parts of your own tax situation or financial situation, one being, exactly, RMDs or required minimum distributions. Typically, if you're over age 70 1/2, you are going to have to make withdrawals from traditional IRAs. With a Roth IRA, you do not have to make withdrawals once you hit 70 1/2.

There are other interactions as well. For example, the fact that Roth IRA income may not be taxable on withdrawal means that things like Social Security taxation could be different, Medicare premiums could be different in retirement and so forth because of that situation. There are a lot of interactions.

Benz: You mentioned that people are often told, well, think about your tax rate now versus what it's likely to be in the future. If it's lower now versus what you expect your tax rate will be in the future, that's the main thing that you should use to determine whether to convert. But you think more nuance is in order when people are approaching this decision. Let's talk about time horizon and how it should fit into the mix. I often get this question, "am I too old to convert my traditional IRA assets to Roth."

Dickson: As you mentioned, Christine, the rule of thumb--and it's exactly that, it's a rule of thumb--is, if you expect your tax rate to be higher in the future, well, then maybe a Roth might make some sense because you're getting a tax deduction now from a traditional; but if your tax rate is going to be higher in the future, that tax deduction isn't really worth it, if you will. Whereas if you could pay taxes now at a lower rate and avoid a higher tax rate in the future, the Roth might make sense because that's the way that the Roth works in taxation.

But that rule of thumb only goes so far. In particular, with respect to time horizon, one of the big issues is--that it's not so much that you get extra tax-deferred growth or tax-free growth in the Roth. I kind of go back to this idea that the same dollars in a traditional and a Roth IRA really aren't the same amounts effectively. That sound like a truth isn't truth kind of comment, right? But $5,000 isn't the same as $5,000 if one is pre-tax and one is after-tax. In essence, if you have $5,000 in a Roth IRA, you are sheltering effectively more than if you have $5,000 in a traditional IRA. Because the tax equivalent amount of that $5,000 in the traditional IRA would be to have that $5,000 and then to have money outside of the IRA that's not being sheltered from taxes.

The benefit of time horizon is, the money that is not being sheltered effectively from taxes because it's held outside of an IRA vehicle is subject to annual taxation and that compounds over time. So, if, for example, you can get taxable money to be sheltered in an IRA, then the time horizon matters and it's better after-tax returns getting compounded. That's why, for example, if you can pay conversion taxes from traditional IRA to Roth--that is, you convert from a traditional Roth--and you pay the taxes from an outside account that is in a taxable account form, you are effectively sheltering more within the IRA because you are bringing that taxable money into the IRA format.

Benz: Another thing that you write about in the paper is the complexion of that IRA bucket, the traditional IRA bucket, and the type of assets that are in there. And one thing you note in the paper is that if someone has made nondeductible IRA contributions that that actually embellishes the case for converting. Let's talk about that.

Dickson: Basically, the way to think about this is, to the extent that you have any nondeductible contributions that are part of the IRA or what would be nontaxable basis when you withdraw the money, think of that as because in a traditional IRA any dollar of earnings is subject to tax in the future upon withdrawal. But any additional dollar of earnings in a Roth is not subject to taxation upon withdrawal. So, in essence, by having nontaxable basis in a traditional IRA if you were to convert that amount, only a portion of the conversion is actually taxable, only that amount that isn't nontaxable basis. But yet, if it were to remain in the traditional IRA, every additional dollar of earnings is taxable. Whereas, if you were to convert that, now every additional dollar of earnings is not taxable.

The effect of that is that in the research that we've done we calculate what is these called the break-even tax rate or a BETR rate. Because of that existence of nontaxable basis that rule of thumb that we were talking about, about your current versus future tax rate being kind of the razor's edge of the decision between converting or not, actually moves to a much lower tax rate as being the break-even because of these effects of the nontaxable basis. So, in essence, it's a much lower threshold that an investor would have in making the conversion decision, and it's not just if your tax rate is higher. It's that even if you're seeing a lower tax rate in the future, it may still make sense to convert because that break-even tax rate is a lot lower than your current tax rate.

Benz: Another thing that you talked about in this BETR paper is the idea of backdoor Roth IRAs.Iit gets a little complicated. But in general, the point is, if doing this conversion allows you to do future backdoor Roth IRA contributions, that's another reason why you might consider doing the conversion. So, let's unpack that whole point.

Dickson: Yes. So, the so-called backdoor Roth IRA is for those taxpayers or investors for whom they are not eligible to make direct Roth IRA contributions because of the income limits associated with it, $133,000, for example, for single filers in 2018. For those investors because there is no income limit on conversion eligibility from traditional to Roth IRA one can, in essence, do a two-step process by which you make a contribution to a traditional IRA on an after-tax basis and then convert those proceeds to a Roth IRA to effectively make a contribution to a Roth IRA. So, you can do this each year up to the contribution amounts.

Now, there are all sorts of things you have to worry about in doing that, one being that some tax advisors would suggest some sort of delay between the time that you make the contribution to the traditional IRA and when you convert it to a Roth. You would want to check with a tax professional about that. But then also the IRA withdrawal rules or conversion rules from a traditional IRA say that the taxation is based on pro rata withdrawals of earnings and any contributions. You might have made a nontaxable contribution, but if you have taxable amounts in that IRA that you are converting, those get included when you're doing it. The idea of using conversions to help facilitate future backdoor contributions is that, again, if you can get money out of what would otherwise be a partially taxable situation, making nondeductible contributions to a traditional IRA, you are better off in many cases or have a lower break-even tax rate if you can convert those dollars so that any future earnings on those original after-tax dollars are not subject to future taxation.

Benz: It's a complicated topic. And you made the important point that people should get tax advice before proceeding. One question I have for you, Joel, and I guess this intersects a little bit with market timing, but the question is, market valuations are not cheap currently, where we sit in early October 2018. If you're paying taxes on these conversions, should that be part of your thinking? Should you be worried about the fact you've probably seen that balance creep up and up and up, and so your tax bill will be higher on the conversion. What's your thought on that question?

Dickson: Yeah, potentially it could be. You are right though. It gets into trying to if you are going to try to predict market returns. What I would say though is that a lot of times what you see is that the amount of income that you have isn't necessarily changing your tax rate. The decision of convert or not is often what's your marginal tax rate today versus what's the marginal tax rate going to be in the future, because the income bands, for example, are quite wide. You can have higher income or even lower income and the same marginal tax rate. That's where again it gets a little complicated when we are talking about tax rates versus income. That said, it used to be the case prior to 2018 that if you did a conversion, you had an option to, in essence, have a do over right now and be able to undo that conversion. That was actually a potentially great financial planning approach. You could do the conversion. If you find that in the future the market went down, you can undo that conversion and then redo it with potentially lower tax bill and lower tax rate even potentially.

Benz: Right. And advisors were really going to town with this maneuver which is one reason why you can't do it anymore.

Dickson: Yeah. Which is why the reason I said it kind of got shut down a little bit. With that option now gone, these conversions become more permanent, if you will, and you've lost that option value of undoing that at least conversion. In that case though, it's still that you may find a conversion is beneficial for any number of reasons and even in the case that maybe the balance being very high, yes, you've got more money, first of all.

Benz: That's a plus.

Dickson: That's a plus. You've benefited from that. But it also gets back to some of the discussions we are having of all of these other interactions that occur. If you keep it in the traditional IRA form, you may have higher required minimum distributions now because the balance is higher. You're having to withdraw more if you get to age 70 1/2. That may increase your taxes by having stay in the traditional IRA.

This idea of kind of multiyear tax planning and tax view of it and thinking about what are the interactions, is a case where partial conversions may be particularly beneficial. You don't have to convert all of it, but getting some diversification, just like we diversify our investments, diversifying our tax risk of the future. We don't know what the tax rate is going to be five, 10, 20 years from now. We don't know what our personal situation will be that affects what our tax rate will be. And so, having a mix of both traditional and Roth can help hedge against those potential uncertain outcomes.

Benz: Joel, complicated topic. Thank you so much for being here to discuss it with us.

Dickson: Thank you, Christine.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.