Roth IRA Conversion – Even for High Tax Bracket People

Roth IRA conversions allow you to move pre-tax funds in a Traditional IRA into a Roth IRA. Once the funds are in a Roth IRA, you will no longer pay any income taxes on future earnings or withdrawals as long as at the time of withdrawal (1) you are at least age 59½ and (2) at least five years have passed since the conversion. The cost of a Roth IRA conversion is paying ordinary income taxes on the conversion amount in the year of conversion. Because of this tax cost, individuals in high income tax brackets are often reluctant to do a Roth IRA conversion. I believe that even those in high income tax brackets should consider Roth IRA conversions if they have excess cash outside of their retirement accounts to pay the income taxes due on conversion.

First, let’s discuss some math. Ignoring estate planning considerations, you are no better off or worse off doing a Roth IRA conversion if the following two statements are true: (1) the funds that you would use to pay the income taxes due on conversion earn the same rate of return outside of your Roth IRA as they would inside of your Roth IRA and (2) your marginal income tax rate stays the same throughout your life.

On the first point, the funds that you would use to pay the income taxes due on conversion are likely to earn a lower rate of return than your Roth IRA since the outside funds are subject to ongoing income taxes on interest, dividends, and capital gains even if you diligently invest the outside funds. Alternatively, perhaps the outside funds would just sit in a bank savings account earning minimal interest or, worse, you would simply spend the money. In any scenario, I believe the first point strongly favors a Roth IRA conversion.

The second point (marginal income tax rates) often causes high income tax bracket people to pass on the Roth IRA conversion. Lower marginal income tax rates during retirement would favor not converting to Roth today. Let’s think about this, however. The current top federal income tax rate is 35%, which is low by historical standards. Your marginal income tax rate during retirement could be higher simply because the government decides to raise income tax rates overall. Also, consider all the sources of taxable income that you might have during retirement: required minimum distributions from IRAs and 401(k)s, pension income, Social Security income, annuity payouts, interest income, and dividend income. If your mortgage is paid off by retirement and you no longer have dependents, then your deductions and exemptions could be lower too. Also, the differences in marginal income tax rates among the highest, second highest, and third highest federal tax brackets are not large.

If your estate is likely to be subject to estate taxes, then there are estate tax benefits to doing a Roth IRA conversion. By converting pre-tax funds to a Roth IRA, you remove the income taxes paid on conversion from your gross estate while creating an investment account that is free of income taxes, subject to certain rules, for your heirs.

If you have excess cash to pay the income taxes on a Roth IRA conversion, I believe the strongest argument for doing a conversion is a behavioral one. A Roth IRA conversion allows you to pay a one-time cost today (the income taxes on conversion) to save a significant amount of income taxes, most likely, during retirement. You do not have to do anything further to achieve the future payoff other than keep your Roth IRA invested and not withdraw from your Roth IRA until retirement. Think of it this way. Paying the income taxes on a Roth IRA conversion is like making a one-time contribution to your Roth IRA, except that you are not limited to $5,000 or $6,000 per year. For many people, the alternative to a Roth IRA conversion is not to diligently invest the funds outside of the Roth IRA but to simply spend the money. A Roth IRA conversion makes it less likely that you will do something unwise with the money that you would otherwise use to pay the income taxes that will be due on conversion.