We’ve gotten a number of questions about Roth IRA conversions recently at Contravisory, and one scenario illustrated the nuance when navigating these planning decisions. We thought we’d share it (anonymized of course) as an example should you be considering similar decisions. 

Recently, “John” reached out to get my input on a plan he had for his retirement. “I did the math and if I retire at age 64, then I should be able to do a series of Roth conversions until age 70, when I start my Social Security,” John said. “I won’t have any traditional retirement assets left! I won’t have any RMDs (required minimum distributions), and the only taxes I’ll owe will be on my pension and Social Security benefits. Plus, after I die, my wife and kids will inherit everything tax-free!” I looked at his plan, and sure enough, he was on track to retire with about $1.5 million already in a Roth IRA and another $500,000 in traditional IRAs. 

The only problem was that his plan had one expensive flaw. 

But before we get to that, let’s do a quick refresher: traditional retirement accounts (401(k)s, IRAs, 403(b)s, etc.) give you a tax deduction now, and every dollar you withdraw in retirement is taxable. The Roth versions of these accounts are the opposite: no deduction today, but withdrawals (including the growth) come out tax-free. Generally, you should contribute to traditional IRAs when your tax bracket is high, and Roth when it is low. You can also move money between these two types of retirement accounts by doing a Roth conversion. 

A Roth conversion is simply a transfer from a traditional IRA account to a Roth IRA account. It’s allowed at any age and any income level, but with two catches. The converted amount is taxable income in that year, and converted dollars generally need to sit in the Roth account for five years before withdrawal. When used well, this creates a tax arbitrage opportunity: deduct contributions during your high-income working years and convert to Roth in the low-income window after retirement but before Social Security and RMDs begin. 

So with that in mind, what was wrong with John’s plan? 

The goal of Roth conversions is to save taxes over your lifetime (and sometimes over the lives of your heirs, if you can). But John’s plan was to effectively pay 22%-24% in taxes when doing Roth conversions to save 10%-12% in taxes later in life. Mathematically, this doesn’t make sense. Here’s why: his pension and Social Security only partially fill the lower brackets and the required distributions on a $500,000 traditional IRA begin at around $20,000 of additional income each year, most of which would be taxed at 10%-12%. John was volunteering to pay double the tax rate to solve a problem he barely had. 

Still, I can understand why this is still a tempting prospect for him. The feeling of simplicity, of certainty, and of being free from the IRS for life and leaving tax-free assets to your spouse and kids sounds like a dream. 

Honestly, I’ve never seen anyone else face the problem of having too much money in tax-free Roth accounts (and I can only aspire to have a similar problem). Most of us can really benefit from contributing to traditional retirement accounts while working and converting those assets to Roth after you retire and are in a lower tax bracket.  

Just remember: the right conversion amount isn’t a guess, it’s a calculation. And it’s different for everyone. Feel free to reach out to us with any questions on your ROTH situation.