To Roth or not to Roth? Part II
I have a tip for those of you who dare to question conventional wisdom about Roth conversions to 401 (k) or IRAs:
Prepare for a major setback.
I should know, because I dedicated last week’s column to questioning this conventional wisdom. I reported on extensive research which found that while Roth conversions often work in the end, it takes a lot longer than most realize for this benefit to be realized, and in any case , the benefit is generally quite small.
The Undefined was conducted by Edward McQuarrie, Professor Emeritus at the Leavey School of Business at the University of Santa Clara. Fully aware that his conclusions will generate this setback, he makes public the indefinite in which he incorporates the myriad of factors relevant to determining whether a conversion makes sense. In an interview, he said, “You may indeed be one of the lucky few who will receive a large and fast payout from a Roth conversion, as opposed to the slow and small payout that I have found to be the norm. But you owe it to yourself to prove it with a spreadsheet.
In this column, I am responding to a number of emails that I received after last week’s column. In each case, I reached out to McQuarrie to get his ideas, which are included below.
“The study fails to mention one potential benefit of a Roth conversion: reducing the minimum required distribution (RMD) on the portion of retirement funds left in a traditional IRA. A few years ago (when tax rates were actually higher), I gradually converted about half of my retirement portfolio into Roths. As a result, my RMD is pretty low every year.
Response from McQuarrie: Reducing your RMD is a common motivation for Roth conversions. But it’s not clear that you’ll be better off for doing it. While I can’t know your specific situation, it’s highly likely that you paid a 28% tax rate on your conversions, in exchange for a reduction in RMD that would otherwise have been taxed at 22%. If so, it will take decades for your conversion to simply break even in terms of net present value. Please see the spreadsheet that I provide on my website for how to do the math. As you will see in this worksheet, for couples married in 2021, the total income (RMD plus Social Security plus other income) must exceed approximately $ 200,000 to be taxed at a rate greater than 22%. This is a significant barrier, and it grows every year as tax brackets adjust to inflation.
“I use my Roth as a kind of trust fund for my daughter, now in her forties. Due to the change in tax law, she will have to cash it within 10 years of my death, but she will never pay income tax like she would on a traditional inherited IRA. This will probably save him a lot more than the tax I paid on conversions.
Response from McQuarrie: I’m not sure you’ve factored in the time value of money here. Suppose your daughter inherits in 20 years, and the traditional IRA in her hands would have been taxed at roughly the rate you paid on the conversion. Instead, you’ve chosen to pass the tax-reduced post-conversion amount on your Roth account to your daughter, who will pay no tax on it or on subsequent appreciation. But you also pass in the future (negative) value of the tax you paid to convert, which would have remained in the traditional IRA to appreciate. She’ll likely be better off, Roth conversions still pay off over decades with roughly constant tax rates. But I challenge you to show in a spreadsheet that the conversion will save him “way more than the tax I paid”, in terms of net present value.
“You failed to mention the time in life when many people would actually benefit from a Roth conversion. I am recently retired, have a small pension, am not yet on social security and am about seven years from RMD. But I have a nice big IRA. When those RMDs hit, I will face a huge tax bill as well as much higher health insurance premiums. Over the next several years, it seems that a Roth conversion every year would be a wise move. I will pay tax on the converted amount at a much lower rate than I will pay on RMD.
Response from McQuarrie: Yesour age and our situation were the exact subject of my article. Let’s be specific about your “big fat IRA”. If he’s single, is he over $ 1.2 million ($ 2.4 million if married)? Otherwise, projecting over seven years, you won’t even have to pay the first tier of Medicare supplements, and you’ll only be in the 22% tax bracket, which I don’t consider “huge”. Nonetheless, if you can convert in the 12% range today, which has an upper income limit of around $ 52,000 for a single taxpayer, then a Roth conversion will pay off in a few years. This $ 52,000 conversion will reduce your RMD in the first year by approximately $ 2,500, saving you over $ 500 in income tax at the 22% rate, and these savings will continue in subsequent years as well. But what funds would you live on during the year of your conversion? If you have taxable income (for example, your pension), you won’t be able to convert up to $ 52,000, which means you will save less than $ 500 in income tax.
Your article on the Roth conversion left out an important issue: a traditional IRA distribution in retirement can make a larger portion of your Social Security benefits taxable, so a rate of 12% is actually closer to 20%. A Roth, on the other hand, does not result in greater taxation of your Social Security payments. This may benefit lower income taxpayers more than it appears when the social security tax issue is neglected.
McQuarrie Response: You’re right: your effective tax rate in retirement will be higher if your income increases enough that some of your Social Security benefits become taxable. If you can do a Roth conversion today at 12%, to save 20 +%, of course that will pay off, and relatively soon. However, what funds will you be living on during the year of conversion? Every dollar of taxable income reduces the amount you can convert to 12%. And can you convert enough at 12% to make a difference? (To get even a $ 1,000 reduction on your first year’s RMD, you’ll need about $ 18,000 to convert at age 65.)
The result I get from this discussion? The wisdom of a Roth conversion, or the lack thereof, is not something you can discover on your own using simple rules of thumb. You have to run the numbers. Be my guest.
Mark Hulbert is a regular contributor to MarketWatch. Its Hulbert Ratings tracks investment bulletins that pay a fixed fee to be audited. He can be contacted at [email protected]