The Best Roth Conversion Strategy Is the One You'll Actually Stick To
Roth conversions can look like a math problem.
How much should you convert? Which tax bracket should you fill? How will the conversion affect Medicare premiums? What might your portfolio look like 20 years from now?
Planning software can help answer those questions. But once you're retired, there's another question the spreadsheet can't answer:
How will it feel to write the check?
I recently worked with a retired couple who still had a few years before required minimum distributions would begin. When I ran their projections, the analysis showed that converting aggressively could produce the lowest projected lifetime tax cost under the assumptions we were using. The strategy meant converting enough each year to reach the 32% federal tax bracket.
For this couple, that would have meant more than $100,000 in additional federal tax in some years.
The numbers were compelling. The question was whether the strategy made sense for the people behind them.
When optimal feels like 0 to 60
Planning software can identify an optimal strategy based on the assumptions and objectives built into the analysis. In this case, the projected benefit of converting more of the traditional IRA sooner was significant.
But there was a trade-off.
The couple would have to write very large tax checks today in exchange for potential tax savings many years into the future.
On paper, the strategy made sense.
Emotionally, it felt like going from 0 to 60.
We explored what a slower approach would look like, but they wanted to understand the aggressive strategy before making a decision. So we walked through it carefully.
The question the software can't answer
At our next meeting, we looked at what the faster strategy would actually mean for their household.
He's the numbers person in their house. She isn't. And she asked the question that mattered most:
How will this affect our day-to-day spending?
Their planned lifestyle spending didn't have to change. But the size of the tax payments would have a meaningful effect on their cash flow and how they felt about their finances.
The software could model the tax brackets, future RMDs, Medicare premiums, and projected portfolio values. It couldn't tell us how comfortable they would be with moving that much money and paying that much tax today.
Once they saw the numbers in the context of their actual life, they decided that rushing through the conversions didn't feel right.
What put them at ease was understanding that the decision wasn't permanent.
We could revisit the strategy every year. We could adjust the amount. And if circumstances changed, we could stop.
Rational versus reasonable
Morgan Housel makes a useful distinction in The Psychology of Money between being rational and being reasonable.
Rational can mean following what the numbers suggest.
Reasonable recognizes that real people have to live with those numbers.
The analysis gave us a rational starting point. My role as a planner was to help the couple decide what was reasonable for them.
What reasonable looked like
We ultimately chose a more measured approach.
The plan included converting a meaningful amount each year, considering the effect of each conversion on their Medicare premiums, and using their taxable brokerage account to pay the resulting tax rather than withholding it from the IRA conversion.
Most importantly, we built in room to reassess.
Roth conversions aren't an all-or-nothing decision. Each year's conversion can be evaluated based on the circumstances at that time. Tax laws can change. Income can change. Spending can change. Markets can change. And so can the household's priorities.
Once we agreed on the approach, she said:
"I feel good."
Common questions about Roth conversions in retirement
When do Roth conversions usually make the most sense?
They can be particularly useful in the years after retirement, when earned income may have dropped and there may be room in lower federal tax brackets before required minimum distributions begin.
Under current rules, RMDs generally begin at age 73 for people born from 1951 through 1959, and at age 75 for people born in 1960 or later.
But the right timing depends on more than today's tax bracket. Future RMDs, Medicare premiums, future tax rates, estate planning, charitable giving, and the possibility of one spouse eventually filing as a single taxpayer can all affect the analysis.
How do Roth conversions affect Medicare premiums?
Roth conversions can increase your modified adjusted gross income, which can affect Medicare's income-related monthly adjustment amounts, or IRMAA.
Medicare generally uses income from two years earlier to determine these surcharges. That means a conversion you make today can affect your Medicare premiums two years from now.
For married couples, the applicable income thresholds affect each spouse's Medicare premiums.
Can you stop Roth conversions once you start?
Generally, yes. Completing one Roth conversion doesn't require you to make another conversion the following year.
Each year's conversion can be evaluated separately based on your income, tax situation, cash flow, and other circumstances.
What you generally can't do under current rules is undo or recharacterize a Roth conversion after it has been completed. That's why the amount deserves careful consideration before the conversion is made.
Is it better to pay the tax from the IRA or from another account?
Paying the tax from funds outside the IRA can allow the full converted amount to enter the Roth, rather than having part of the conversion withheld for taxes.
But that doesn't automatically make it the better choice. The right approach depends on your cash reserves, taxable investments, tax situation, and broader financial plan.
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Igor Aronov, the publisher of this content, is a registered investment adviser representative and owner of FAR Financial Inc.