An important factor in determining whether to do a Roth conversion, and if so how much to convert, is the difference (if any) between the tax rate that would apply to a conversion and the rate that would apply to later withdrawals from the existing account if it is not converted. You might, for example, find that you’ll pay 28% on a conversion, while a projection indicates that if you don’t convert you’ll eventually pay 25% on withdrawals. I’m going to call this second number your anticipated tax rate on withdrawals, or ATRW.
It’s widely understood that having a conversion tax rate higher than ATRW makes a Roth conversion less attractive. Some have mistakenly concluded that it’s fatal. In reality, it’s possible for a Roth conversion to produce significant long-term benefits even in this situation. Before we examine the effect we should get a firmer grasp of the tax rates we’re comparing.
Multiple rates apply
A Roth conversion isn’t necessarily taxed at a single rate. Your income without the Roth conversion may leave you in the 25% bracket, but only $10,000 below the level where the 28% bracket kicks in. In this situation, converting a $30,000 traditional IRA to a Roth will require you to pay tax at the rate of 25% on the first $10,000 converted and 28% on the remaining $20,000.
The same principle applies to the withdrawals you would take from a traditional retirement account if you don’t convert. You might expect that each year’s withdrawals will be taxed partly in the 15% bracket and partly in the 25% bracket.
Compare lowest with highest
A Roth conversion doesn’t have to be an all-or-nothing choice. You’re allowed to convert whatever portion makes sense in your situation. This means you should not be comparing the overall or average rate of tax on a full conversion with the overall or average rate on withdrawals.
Our book on Roth IRAs and other Roth accounts
The first dollars you convert are taxed at the lowest bracket available based on your current tax situation. In the example above, you can have $10,000 in additional income in the current year before you move from the 25% bracket to the 28% bracket. If you convert $30,000, your average tax rate would be 27%, but you’re allowed to convert just $10,000 and pay 25% on that amount.
Now let’s look at the other side. If you don’t convert, your withdrawals will be taxed at more than one rate. You might find that they’re taxed mostly at 15% but partly at 25%, for an average tax rate of 17%. Yet the first dollars you convert will eliminate distributions that will be taxed at the higher rate, or 25% in this example.
When we look at your overall or average rates for the tax you’ll pay on a total conversion and the tax you’ll otherwise pay on withdrawals, we find that the conversion tax rate is 27% and ATRW is 17%, which makes the conversion appear unattractive. Yet you can do a partial conversion that’s taxed at 25%, and also eliminates withdrawal income that would be taxed at 25%, eliminating the disadvantageous spread in tax rates. The dollar amount that produces this effect is the amount that would fill your 25% bracket this year or, if lower, the amount needed to eliminate income taxed in the 25% bracket during the years you’re withdrawing money from the traditional account.
In analyzing the benefits of a possible Roth conversion, the proper tax rate comparison is between the lowest tax rate that may apply to a partial conversion and the highest tax rate that will apply to withdrawals if you don’t convert. This will tell you the tax rate tradeoff on the first dollars converted. Based on this analysis you may find that a partial conversion is beneficial even though a full conversion is unattractive.
I’ll be addressing additional aspects of the tax rate comparison in future posts. In particular, it’s important to understand that a Roth conversion can produce long-term benefits even in situations where the conversion tax rate is higher than ATRW — but only under certain conditions.
Tags: feature, Roth conversion, tax brackets
