POSTED ON SEPTEMBER 11, 2023

By:  Eric Morrison JD*, CFP®, CTFA

Wealth & Tax Strategist for MassMutual Private Wealth & Trust, MassMutual Trust Company, FSB

This article will … Explain the basics of an IRA Roth conversion and the tax advantages it may offer. Look at the reasons why it might make sense for some people. Note the circumstances where such a conversion would work to the detriment of some people.

In my conversations with clients and financial professionals, the number one question I have received regarding traditional IRAs is whether the client should pursue a Roth conversion.

In a Roth conversion, the IRA owner takes a distribution from their traditional IRA, pays income tax on the distribution, and rolls the funds into a Roth IRA. For the year of the conversion, the owner will have a larger-than-normal income tax bill. Once the conversion is made, however, it is likely that all future distributions will be income-tax free. If one can afford the tax payment using non-retirement dollars, this technique becomes even more impactful.

Why do people pursue this strategy? Typically, there are two motivating factors:

1. Market performance year to date.

2. An expectation of higher income tax rates in the future.

Other factors that financial professionals and clients consider are the percentage of Social Security on which clients will need to pay income tax in the future and lessening the income tax impact on the next generation. (Related: When to file for Social Security)

All of these are valid points. However, when I run the numbers, in many cases there is not a distinct advantage to either a Roth conversion or leaving the assets in a traditional IRA. As such, the determination really comes down to when the IRA owner wants to pay income tax on their IRA, either now or in the future.

Following are some points to consider when contemplating a Roth conversion:

Reasons a Roth conversion may make sense:

• The account owner can afford the tax liability from the Roth conversion without using dollars from retirement funds. (The account owner should avoid making tax payments from converted funds.)
• The IRA market value is down due to a market pullback, and, therefore, there is less taxable income generated.
• The account owner plans to leave the funds to their children and expects the children to be in a high tax bracket.
• The account owner’s income and tax bracket in the year of conversion are lower than what they expect in future years.

Reasons a Roth conversion may not make sense:

• One cannot recharacterize the conversion (i.e. if Roth conversion assets depreciate in value AFTER the conversion, the account owner still must pay tax on the value of the assets at the time of conversion).
• The conversion moves the account owner into a higher tax bracket in the year of conversion.
• The account owner expects to be in a lower tax bracket in retirement (i.e., less income in retirement or the owner expects to move to a state with lower or no income tax, etc.)
• The account owner needs to use dollars from retirement funds to pay income tax on the Roth conversion.

Other considerations:

• Time horizon — A longer time horizon generally means the account owner can benefit from a longer period of tax-free earnings accumulation. During the account owner’s lifetime, there are no required minimum distributions (RMDs) from Roth IRAs. (Related: RMDs explained)
• RMDs cannot be converted to a Roth IRA.
• The one-rollover-per-year limit does not apply to Roth conversions, thereby allowing for the conversion of smaller amounts over two years (but within 12 months), if desired, in order to spread the tax liability.

The following case study helps to illustrate the application of the competing factors listed and discussed above.

Weighing Roth conversion: A real-life example

This case first came to me in June of 2022. At that time, our client (age 63) had recently retired and was transitioning from high W-2 wages to a mix of investment and retirement income. His spouse was also age 63.

The question was three-fold:

1. Should the client and spouse convert their traditional IRAs to a Roth IRA?

2. If yes, when should they begin to convert?

3. Should both convert or just one?

A few more details:

• Husband’s IRA market value: $1.3 million
• Wife’s IRA market value: $162,500
• Nonqualified assets: $3,500,000

In evaluating this case and hammering out the numbers, we also made some assumptions about investment growth (7 percent annually) and inflation (3 percent).

What the numbers bore out was interesting:

• If the client and spouse decided to convert in 2022, with a lower market value due to investment markets being down 10-20 percent last year, the overall tax due was $492,000 versus $519,000 if they decided to wait until 2023. The 2023 tax due was higher due to an assumption that the accounts would recoup some losses from the first part of the year.
• However, if they waited until 2023, with the assumption of better performance, at their combined life expectancy, there was a possibility of an additional $700,000 or so available for their remainder beneficiaries.

Ultimately, the client and his spouse decided to revisit at the end of the year, and with the projections working out, they decided to convert in 2023.

Conclusion

When weighing the conversion question, evaluating the numbers is important. It’s also important to make informed decisions and keep in mind that conversion may not make sense. That’s why it’s usually helpful to have a conversation with your financial professional and tax advisor. That can help clarify what the considerations mean in terms of your financial goals as well as any needs for planning for a surviving spouse and/or future generations.

The information provided is not written or intended as specific tax or legal advice. MassMutual and its subsidiaries, its employees, and representatives are not authorized to give tax or legal advice. You are encouraged to seek advice from your own tax or legal counsel.Opinions expressed by those interviewed are their own and do not necessarily represent the views of MassMutual.

MassMutual Trust Company, FSB, is a federal savings bank and is a wholly owned subsidiary of Massachusetts Mutual Life Insurance Company.

Provided by Christopher Price, courtesy of Massachusetts Mutual Life Insurance Company (MassMutual). California insurance license number: #4196813.
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