The latest tax report explored when it’s smart for seniors to convert taxable traditional IRAs to tax-free Roth IRAs. It prompted a flood of questions from Journal readers asking for more details, so we’ll discuss some of them.
Roth IRA conversions are not suitable for all savers. But they often make sense for people with large traditional IRAs, which many have because of rollovers from traditional 401(k)s.
The most important factor is the tax rate on the Roth IRA conversion amount versus the tax rate on the money at the time of withdrawal – tax arbitrage, if you will. If the rate upon conversion will be lower than the rate upon withdrawal, conversion is often a smart move.
What about “opportunity cost,” the idea that dollars used to pay conversion taxes miss out on investment growth? This is not a problem if the tax rates are the same for the contribution and the withdrawal. Although the conversion tax is paid earlier, it is also smaller, and the tax deferred on the traditional IRA grows as the funds grow.
Ed Slott, Roth IRA advocate and CPA, gives a simplified example: Jane and Fred each have traditional IRAs with $100,000. These are invested identically and double over a period of 10 years. The tax rate is 30%, so Jane pays $30,000 in taxes to convert to a Roth IRA and has $70,000 to invest. In the end, she has $140,000 to withdraw tax-free.
Meanwhile, Fred doesn’t convert and his pot grows from $100,000 to $200,000. But if he withdraws it, he will owe $60,000 in taxes. That leaves him with $140,000 after taxes, the same as Jane.
What makes a Roth conversion smart or not is whether the tax rates vary. If Jane’s tax rate on a Roth conversion is 20%, but her tax rate upon withdrawal is 30%, she’s probably a winner. And if Fred’s tax rate on a conversion is 30%, but his tax rate upon withdrawal is 15%, that’s not the case.
Of course, evaluating a Roth conversion forces savers to guess the future. But sometimes that is not difficult, for example if a saver moves from a state with high taxes to a state with low or no taxes. The death of a spouse can also subject the surviving spouse to a “widow’s penalty,” leaving him or her as the sole filer with a higher top rate.
But savers who use outside funds to pay the conversion tax to keep more dollars in the Roth IRA should consider their source. If the tax money is in a low-interest account, it may be smart to use it to pay conversion taxes. But if the saver is going to sell shares and pay 15% on the capital gains, think further. Can selling a loser offset that tax?
Investment returns also matter, and with that comes more guesswork. The higher the return, the greater the benefit of the Roth IRA. In general, investors have done better betting on the long-term growth of their assets rather than against it.
This is possible if you are the surviving spouse of the owner. This involves converting money from the inherited IRA into your own IRA and then doing a Roth conversion.
But most other heirs of traditional IRAs cannot make such conversions. And whether it’s a traditional or Roth IRA, most heirs must empty the accounts within ten years of the original owner’s death.
The five-year waiting period for tax-free withdrawals from the Roth IRA confuses many savers when evaluating conversions. There are actually two five-year rules, but only one applies to people aged 59½ or older. The good news is that most older IRA owners won’t have a problem with it. Here is a summary.
If a saver age 59½ or older has at least one Roth IRA open for five years or more, there is no five-year waiting period for tax-free withdrawals after a conversion.
If a saver age 59½ or older has never had a Roth IRA and is converting money from a traditional IRA, things are a little different. The saver can withdraw the converted amount tax-free for the first five years after the conversion, but not the income on it. If the saver withdraws the earnings before then, it is taxable, but there is no 10% penalty, as is the case for savers under age 59.5.
What happens if a saver age 59½ or older makes a Roth conversion, subject to the five-year rule, and dies three years later? Then, in two years, the heirs will be eligible for completely tax-free withdrawals. Until then, withdrawals of the conversion amount are tax-free, but withdrawals of earnings are taxable. Again, there is no 10% penalty.
Note: For savers making Roth conversions, the withdrawal rules are favorable because they assume the amounts converted come out before any gains. Only after the full conversion amount has been withdrawn will payouts be considered income that may or may not be taxable.
No, you shouldn’t. Leaving traditional IRAs to charities is a tax trifecta because there is no tax on the dollars coming in, no tax on growth, and no tax on the dollars donated to the charity.
Converting some or all of your traditional IRA to a Roth IRA means paying taxes when you don’t have to and reducing the amount the charities receive.
Many savers looking to make Roth IRA conversions face this dilemma with the Medicare Part B and D surcharges for higher-earning taxpayers, known as Irmaa.
Careful planning is important because even a dollar more in income can lead to much higher Irmaa fees. It is especially difficult because the allowances are based on income from two years ago. Thus, the recently announced 2025 Irmaa allowances will use recipients’ reported income for 2023 and include the filer’s income from Roth conversions made that year.
Some savers trying to avoid Irmaa use the latest known Irmaa brackets to provide a margin of safety. Others look to websites – such as The Finance Buff – that estimate future Irmaa surcharges based on available but incomplete data.
