User:Fyre4ce/Roth conversion

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A  is the transfer of funds from a pre-tax retirement account to a Roth retirement account. If you have a traditional IRA, you can convert part or all of the account to a Roth IRA. Conversions may also be possible from employer plans (such as a 401(k)), which may allow in-service distributions and/or in-plan Roth rollovers, and conversions to a Roth IRA are always allowed upon separation. The converted amount counts as taxable income in the year the conversion takes place (unless there is non-deductible basis in the account, in which case only a portion of the conversion is taxable), but in return, the money will grow tax-free in the Roth account, and you will not pay any tax on that withdrawal if you meet the Roth distribution rules.

Roth conversions are usually done as part of a long-term tax planning strategy. The gain or benefit depends on your current marginal tax rate, your marginal tax rate when the money will eventually be withdrawn, and how you would otherwise invest the funds that you use to pay the taxes. They are also done as the second step in the Backdoor Roth IRA and Mega-backdoor Roth, with the intent of contributing more to Roth accounts than would otherwise be allowed.

Technically, the tax code limits the term "conversion" to IRA to Roth IRA transfers. Transactions that are analogous to Roth conversions for tax purposes include "qualified rollover contributions" from qualified employer plans to Roth IRA's, and "in-plan Roth rollovers" from non-Roth sub-accounts of employer plans to the designated Roth sub-account in the same plan. For simplicity, this page refers to all three transactions as "Roth conversions", because they have the same tax behavior and the considerations for doing each are nearly identical.

Whether, when, and how much to convert
In a simplistic sense, Roth conversions of pre-tax money will be advantageous whenever the tax rate on the conversion is less than the tax rate on a later withdrawal, for example in retirement. The reasoning is similar to that behind traditional versus Roth decisions. When current tax rates are lower than at later withdrawal, Roth conversions increase the after-tax value of your accounts more than simply contributing the tax money directly into a Roth account, for mathematical reasons described here. Because Roth dollars are worth more than pre-tax dollars, converting pre-tax money to Roth and paying the taxes with funds outside retirement accounts is a way to effectively contribute additional tax-protected money without counting toward annual contribution limits. Non-retirement funds could be cash flow from earned income, cash savings, or proceeds from the sale of taxable investments. For this reason, Roth conversions are valuable even when tax rates are slightly higher than at withdrawal; the mathematical reasoning is analogous to traditional versus Roth decisions when maxing out your retirement accounts. The following table summarizes the recommendations for Roth conversions based on current and predicted future marginal tax rates:

These guidelines apply when the conversion amount is relatively small compared to the total pre-tax balance. If the conversion is a large amount and you expect to have a lower marginal tax rate in future years, wait until then to convert. Also note that the decision to convert a given amount only applies so long as the marginal tax rate remains the same. Once the marginal tax rate increases, for example when crossing into the next tax bracket, the decision of whether to convert more money should be made separately. Typically, this results in converting to the top of one's current tax bracket this year, and converting the remainder in future year. Likewise, consider the possible effect on future marginal tax rates by making large Roth conversions - if you substantially reduce your pre-tax balance, your predicted future tax bracket may be lower due to smaller taxable withdrawals or Required Minimum Distributions (RMDs), reducing the benefit of further conversions. Due to the usually progressive nature of the US tax system, a major overall goal of tax-planning with Roth conversions is to equalize tax rates as much as possible across all the years of one's life.

Marginal tax rate now
For the purpose of Roth conversions, a taxpayer's marginal tax rate today is best thought of as a curve of tax rate vs. converted amount, rather than a single number. This is because marginal tax rate usually changes as taxable income is added, for example, when taxable income crosses into a higher bracket. A useful spreadsheet for generating these plots is the Personal Finance Toolbox. With minimal input in the appropriate green cells, including filing status and ages:

and income other than the Roth conversion amount:

it automatically generates the marginal tax rate applicable to that situation for any range of conversion amounts:

The "170" in the upper right of the last picture is the x-axis increment, adjustable as needed. For a simple progressive tax curve, usually the best conversion amounts are up to one of the marginal tax rate boundaries. For a more complex non-progressive curve, like the one in this example, local minima of the blue "Cumulative" curve are usually the best candidates for conversion amounts - in this example, about $54,000 @ 14.5%.

Estimating future marginal tax rate
Predicting one's future marginal tax rate is considerably more difficult; it depends on future tax laws, future behavior of government programs such as Social Security, the pattern of future contributions and withdrawals, and future investment growth, all of which are hard to predict. The traditional versus Roth page lays out two potential hand calculation methods for estimating one's future marginal tax rate at a single point in time. Forum user fyre4ce has also published a spreadsheet which automates these calculations and has the capability to vary many of these inputs by year.

Using a spreadsheet
With a known marginal tax rate today and an estimated future marginal tax rate, and considering a single future withdrawal date, the above decision table can be used to make reasonably good decisions in the current year. Calculating the numerical value of these decisions has been automated in several tools:
 * The 'Misc. calcs' tab (near row 150) in the Personal finance toolbox.
 * Traditional versus Roth (401(k) or IRA)
 * Fyre4ce's Future Value spreadsheet

When some Required Minimum Distributions will be reinvested in a taxable account, the situation gets even more complicated, and unlike for a single future withdrawal date, a simple equation has not yet been derived. Two spreadsheets that have been published for this use are
 * McQ's spreadsheet
 * MDM's spreadsheet

For a more complete analysis, forum member BigFoot48 has created a spreadsheet, Retiree Portfolio Model (RPM), for use by retirees, or those nearing retirement, which will estimate the financial impact on your portfolio, including income taxes and RMDs, from doing Roth conversions. Use this spreadsheet to determine if Roth IRA conversions may be worthwhile for your personal situation. Yearly results are calculated and provided (such as income, expenses, taxes, inheritances, and asset sales over a selectable 1 to 40 year period) for both doing conversions, and not doing conversions, so an easy comparison can be made.

Details

 * Roth conversions are fully taxable if you have no non-deductible basis. If you have a non-deductible basis in a traditional IRA, an IRA conversion is taxable according to the pro-rata rule. Roth conversions from an after-tax 401(k) are pro-rata with respect to the basis in that account only, although in practice, after-tax 401(k) conversions are usually done as part of a Mega-backdoor Roth, so the conversion would be the entire account balance, the gains would be taxable, and the basis would be non-taxable.
 * Roth conversions are considered a retirement account withdrawal, and you will be issued a IRS Form 1099-R:
 * For conversions from a traditional, SEP-IRA, or SIMPLE IRA to a Roth IRA, the form should have distribution Code 2 in box 7 of you are under age 59.5, or Code 7 if you are at least age 59.5, and the IRA/SEP/SIMPLE box should be checked. Box 2a (taxable amount) should be left blank, and the "Taxable amount not determined box" should be checked in 2b. The conversion will be reported on Part II of IRS Form 8606, and gross and taxable amounts (calculated on Form 8606) flow to Form 1040 line 4.
 * For a conversion from a qualified plan to a Roth IRA, or an in-plan Roth rollover, the form should have distribution Code G in box 7. If converting from an after-tax sub-account, the basis of the conversion will be reported in box 5, and the taxable amount reported in box 2a, which should total to the gross amount in box 1. If converting from a pre-tax sub-account, boxes 1 and 2a should have the amount of the conversion, and box 5 should be blank. The gross and taxable amounts get reported on Form 1040 line 5.
 * Like a normal withdrawal, the taxable portion of a Roth conversion is taxed at ordinary income tax rates, but is not subject to payroll tax or Net Investment Income Tax (NIIT).
 * Roth conversions are exempt from early withdrawal penalties. However, any taxes withheld from the conversion are not exempt; see below
 * There is no statutory limit on how much money can be Roth-converted
 * Conversions are always taxable in the year they were done. Unlike IRA contributions, there is no option to count conversions early in the calendar year against the prior tax year.
 * Starting in 2018, conversions can no longer be recharacterized; you cannot undo a conversion for the tax benefit.

Benefits

 * Roth conversions are a powerful tax planning tool, allowing investors to capitalize on tax rates in any year they are lower than or similar to when money will eventually be withdrawn, such as in retirement, by RMD, or by potential heirs. As long as the taxes are paid with funds outside the conversion, there are no early withdrawal penalties for Roth conversions at any age.
 * Tax benefits may also be realized at the state level, for example by Roth-converting when living in a low-tax state if there's a possibility of retiring in a higher-tax state, or if you live in a state that excludes some pension income (which usually includes Roth conversions) from taxation.
 * When the taxes are paid with funds outside the conversion, Roth conversions give investors tax-protected growth and potentially asset protection on more money, because Roth dollars are worth more than pre-tax dollars.
 * Roth accounts have no RMD's, so conversions are an advantage whenever expected RMD's are more than one expects to spend.
 * Especially for investors with mostly pre-tax assets, Roth conversions can add tax diversification and reduce tax risk. Roth accounts can also provide a source for funding large one-time expenses that would otherwise cause high tax rates.
 * Converted money can be withdrawn tax- and penalty-free after a five-year waiting period, even if you are under age 59.5.
 * Conversions have estate planning benefits in many situations, such as when leaving money to higher-tax heirs or into trusts.

Cautions

 * Check for unexpected adverse tax impacts before converting, by using tax software or by consulting a tax professional. Often, one's marginal tax rate is very different than their tax bracket, due to phase-ins of various taxes and phase-outs of credits and deductions, such as Social Security taxation or pushing qualified dividends to be taxed at a higher rate. There may even be off-tax-return impacts, such as IRMAA (increased Medicare premiums for those age 63+), Expected Family Contribution, and loss of ACA health insurance subsides. Some tax impacts may also be present in the future, and these would have to be weighed according to a comparison of marginal tax rates.
 * Leave enough money in pre-tax accounts to fill up 0% and low-rate brackets with future withdrawals, and also to fund future deductible expenses, such as charitable donations and unreimbursed medical/long-term care expenses.
 * A Roth conversion when the taxes are paid with non-retirement money reduces liquidity, until the five-year waiting period has elapsed. Make sure you will have a robust emergency fund remaining after any conversions.
 * Any taxes withheld from a conversion are subject to the 10% early withdrawal penalty, if you are under age 59.5 and an exception does not apply.
 * For those affected, Required Minimum Distributions (RMDs) must be the first withdrawal to leave an account each year. If you Roth-convert before the entire RMD is withdrawn, some or all of the conversion will be considered to have been an excess Roth IRA contribution, and you will owe a 6% excise tax for each year the excess is not withdrawn (if not corrected before your tax filing deadline). Also, any earnings on the excess Roth contribution must be withdrawn as well, and are taxed as ordinary income.
 * Brokerages can typically take up to a few business days to process a conversion, especially late in December when they get many withdrawal and conversion requests. If you care about which tax year the conversion gets processed on (very likely), then submit conversion requests at least one business week before the end of the year.
 * A Roth conversion is irreversible, so make sure you have reasonable confidence that it makes sense from a tax planning perspective. Pre-tax money can always be converted later, and this is an advantage when the future is uncertain.

Low-income/low-tax years
Roth conversions are more likely to be beneficial when marginal tax rates are low, such as in the following situations:


 * when unemployed or working fewer hours
 * when going back to school full-time instead of working
 * early in your career before you reach your peak income
 * when taking time off to care for a family member
 * when large medical expenses, charitable donations, or other deductions lower your taxable income
 * when living in a low-tax or tax-free state, and expecting to move to a high-tax state

However, low income does not always lead to a low marginal tax rate, due to potential phase-out of credits available to lower-income taxpayers. Be sure to check for the potential impact of Roth conversions using tax software or consulting with a tax professional.

Roth conversion ladder
Once a Roth conversion occurs, a five year period starts, after which the taxable portion of the conversion can be withdrawn tax- and penalty-free, even if you are under age 59.5. (The non-taxable portion, if any, can always be withdrawn tax- and penalty-free, as can direct contributions to Roth accounts; see Roth IRA distribution rules.) This provides an alternative to Substantially Equal Periodic Payments (SEPP) as a way to access pre-tax funds for early retirees who are younger than 59.5. Early retirees begin conversions, and after the initial five-year waiting period, can withdraw the conversion each year based on the converted amount five years prior. Note that the five-year period is often closer to four years, as the five years starts January 1st of the year of the conversion, even if done late in the year. (Also note: the five-year waiting period for conversions is different from the rule that requires the taxpayer to have had a Roth IRA open for at year five years, in addition to being at least age 59.5, for withdrawals of earnings to be tax-free.)

Compared to a SEPP, a Roth conversion ladder gives early retirees more flexibility to choose the amount of money that will be withdrawn each year; SEPP withdrawals can only be calculated according to three approved formulas. SEPP's are also more complicated to set up, usually requiring professional assistance. A major downside of a Roth conversion ladder is the initial five-year waiting period. Early retirees typically fund this period using taxable investments, so those without sufficient taxable investments should likely choose the SEPP.

In retirement before collecting Social Security
If you might retire before taking Social Security, you are likely to be in a very low tax bracket before Social Security starts. Delaying Social Security until age 70 is usually the right choice for those with average or better health, but it also increases this valuable time for Roth conversions. To see if Roth conversions during this time would benefit you, estimate your taxes and marginal tax rate during the early retirement period as well as for the years you are over age 70 and taking Social Security (if eligible) and Required Minimum Distributions (RMDs) from pre-tax accounts. If your post-age-70 tax rate is higher, it is likely advantageous to convert during the early retirement period, while delaying Social Security.

Social Security benefits are taxed at a variable percentage that depends on other taxable income. With no other income, no Social Security benefits are taxable, but as other income is added, the percentage of benefits that are taxed phases in rapidly, resulting in a marginal tax rate 1.5x or 1.85x one's base tax bracket. This creates tax rate "bumps" for some taxpayers. For those in or slightly above one of the rate bumps, one or several large Roth conversions to get your future taxable income under the spike will likely result in a net lifetime tax savings. Roth withdrawals do not count as taxable income, nor affect the percentage of Social Security income that is taxed.

Roth conversions at age 63 or older potentially expose a taxpayer to Income-Related Monthly Adjustment Amount (IRMAA). IRMAA brackets behave differently than normal tax brackets, and also have a two-year delay, which makes planning difficult. However, Roth conversions will also lower future income and may reduce future IRMAA costs, so the two effects must be weighed against each other.

RMDs that you will reinvest, not spend
A Roth IRA is exempt from required minimum distributions while you are alive. Therefore, if the Roth conversion is close to break-even based on the above marginal rate analysis, but you might be forced to take distributions from your traditional IRA which are more than you need to live on, there is an advantage to conversion; you will keep more money growing tax-deferred for longer.

This advantage can be slight or significant. See p. 7-8 of To Roth or Not To Roth and for more discussions.

In down markets
Being able to convert a larger fraction of one's traditional account in a down market when the marginal tax rate for the conversion is favorable is a good thing, but a down market does not make incurring a higher marginal tax rate favorable. The advantage of a down market is difficult to take advantage of in practice. If a Roth conversion makes sense, it's generally best to do it as soon as possible to get tax-free growth for the longest time possible. If a Roth conversion opportunity happens to line up with a market crash, that is fortuitous for the investor, but waiting for a crash to convert would be market timing, which data shows is difficult or impossible to do reliably. Likewise, Roth-converting during a crash when it doesn't makes sense based on marginal tax rates is not beneficial. It doesn't matter for the decision that asset prices used to be higher; all that matters is their predicted growth going forward from today.

Incurring capital gains tax
If appreciated taxable investments must be sold to cover the tax cost of a Roth conversion, incurring capital gains tax, then the value of the conversion is reduced. As a general rule, Roth-converting while incurring some capital gains tax at long-term rates still has a break-even withdrawal tax rate lower than the rate on the conversion, but the benefit will be reduced slightly. Paying short-term rates to convert is not recommended, but likely not necessary. The Future Value tool can calculate the impact of capital gains for a single year, and MDM's Spreadsheet can include the effect over a whole retirement, and even for heirs.

Example
A taxpayer is in the 24% bracket and expects to also be in the 24% bracket in retirement. Investments are expected to grow at 8%, with a 2% yield, with a 15.9% dividend tax rate and a 15% capital gains tax rate, and will be withdrawn in 20 years. He is deciding whether to convert $10,000 of pre-tax money to Roth. If the $2,400 tax can be paid with cash, the future value of the Roth account will be $46,610 (=$10,000 x (1+8%)^20). If he does not convert, the $2,400 will grow to $10,546 with a basis of $4,184 for an after-tax value of $9,591, and the pre-tax account will be worth $35,423 ((=$10,000 x (1+8%)^20 x (1-24%)), for a total value of $45,015. The Roth conversion has a 3.54% advantage.

Instead, suppose the taxes must be paid by the sale of taxable investments that are already 60% unrealized gains (basis 40% of value). Selling these investments will only yield 91% (=1-(60%*15%)) of the sold value, so $2,637 (=$2,400 / 91%) must be sold to cover the cost. The basis of the sold shares was $1,055. If he does not convert, the $2,637 investments will grow to $11,589 and the basis will grow to $3,015, for an after-tax value of $10,303, and including the pre-tax account the total value will be $45,726. The Roth conversion has a 1.93% advantage, smaller without any capital gains tax, but likely still worth doing.

Paying conversion taxes with converted funds
Roth conversions where the taxes are paid from the converted amount, as opposed to from non-retirement funds, are less valuable, because they do not increase your tax-advantaged account balances as much. Rather than using the more complex formula, the decision to convert with taxes paid with converted funds comes down to a simple comparison of marginal tax rates. Nonetheless, this type of conversion is still advantageous whenever your current marginal tax rate is lower than your predicted future marginal tax rate, but you have limited or no taxable assets.

Take heed that the IRS treats any taxes withheld from a Roth conversion as a distribution from the account, which will have early withdrawal penalties if you are under age 59½ and one of the early withdrawal exceptions does not apply. In these cases, the penalty will be 10% of the tax withheld (not the entire converted amount). In low-tax years, it may still make sense to do the conversion and pay the penalty if you do not expect a similar opportunity in future years. For example, if you expect a marginal tax rate in retirement of 22% and can convert a $20,000 pre-tax balance to Roth this year for a tax rate of 10%, you would pay a 10% penalty on the $2,000 withdrawal (=$200) and your overall tax rate on the conversion would be 11%, still much lower than the expected future tax rate.

Converting with non-deductible contributions
If you have non-deductible contributions in your traditional IRA, you do not pay tax on the amount of non-deductible contributions. If you make a partial conversion, you must prorate your deductible and non-deductible contributions across all traditional IRAs (including SEP and SIMPLE IRAs) as of December 31 of the year you convert. For example, if you had a traditional IRA worth $10,000 that contained $5,000 in non-deductible contributions and you converted (or withdrew) $3,000 leaving $7,000 in that IRA at the end of the year, then half of the $3,000 is taxable. To compute the taxable amount of your conversion, use IRS Form 8606. See the main page on the "pro-rata" rule for details.

If the tax cost of converting the entire IRA balance is too great, roll the pre-tax portion of the IRA into an employer plan (such as a 401(k) or Solo 401(k)), then convert the non-deductible amount separately for no tax cost. If you do not have, and do not expect to ever have, an employer plan with reasonable investments and that can accept incoming rollovers, it's best to convert the balance quickly rather than waiting. If you wait for your $10,000 traditional IRA with $5,000 in non-deductible contributions to grow to $20,000 before converting, you pay tax on $15,000 rather than $5,000, tripling the tax but only doubling the amount converted.

Roth conversions on mostly non-deductible balances are a central part of the Backdoor Roth IRA and Mega Backdoor Roth strategy, which involve non-deductible contributions to a Traditional IRA and After-tax 401(k) respectively, followed by Roth conversion of the entire amount. See the respective wiki pages for details on those two strategies.

Estate planning
Roth conversions may also be beneficial for estate planning. If you expect your heirs to have a higher marginal tax rate than you, Roth conversions during your lifetime will increase the after-tax value of your estate to your heirs. Someone leaving everything to tax-exempt charities should be less willing to convert than someone leaving everything to children who may be in their own peak earning years. Also consider that IRAs inherited after the passage of the SECURE Act are required to be fully distributed by the end of the tenth year after your death. If you expect to leave large pre-tax IRAs to your heirs on a per-person basis, they could be required to pay high tax rates on large required withdrawals, and Roth conversions are a useful mitigation as well.

Another potential benefit of Roth conversions for a married couple is to insure against the early death of one spouse. If this happens, the surviving spouse will face the same size RMD's but will pay income taxes on the single taxpayer brackets, potentially raising the tax rate significantly. Roth conversions that are close to mathematically break-even with the married brackets may provide inexpensive insurance against this possibility.

Roth conversions may be valuable when leaving assets into trust. Trusts are required to pay taxes on undistributed income according to the trust tax brackets, which are highly compressed (as of 2023, the top 37% rate begins at just $14,450). If you are considering leaving assets into trusts, you definitely need to consult an estate planning attorney, who can advise on the details and on tax strategies.

How to convert
Many brokerages allow conversions of assets in-kind, meaning moving existing investments from a pre-tax to Roth account without buying and selling, or simply as cash. In-kind conversions eliminate your time out of the market, and may also avoid any purchase fee or redemption fee. However, you are exposed to market fluctuations for up to a few days while the conversion is being processed, so a cash conversion may be better if you're trying to convert a very precise amount (eg. coming in underneath an IRMAA spike).

With Vanguard, to convert, you buy shares (or open a new account) in your Roth IRA, and fund it by "selling" shares in your traditional IRA. Other brokerages typically have an online Roth conversion form, specifying the accounts the conversion is coming from and going to, which assets and how much are being converted, and your elections for tax withholding. Conversion requests can also typically be given over the phone. Most brokerages are inundated with withdrawal and conversion requests at the end of the year, so if it would be undesirable for the conversion to recorded on the next tax year (very likely), submit the request at least one business week before the end of the year.

If you are converting from an employer plan while you are employed, you will need to either convert pre-tax or after-tax funds into a Roth sub-account (an in-plan Roth rollover), or roll pre-tax or after-tax funds out into a Roth IRA (an in-service withdrawal). Plan providers aren't required to offer either of these options; contact your plan provider for details on what types of conversions are allowed and how they work. Upon or after separation, conversion of some or all of the pre-tax and after-tax funds is always possible by rolling them out into a Roth IRA.