Roth: How Much Should You Convert & Should You Contribute to a Roth 401K/IRA vs. a Traditional 401K/IRA?

Paying Taxes Earlier Than Required On a Conversion

But first, let me address a pet peeve.  I’ve heard many advisors and CPAs discuss the Roth break-even.  When you pay taxes earlier than required on a conversion, or forego the tax deferral with a Traditional 401k/IRA contribution by contributing to the Roth versions, yes, over the near term your net worth is going to be lower.  This observation is based on your pre-tax net worth, however, and we should be focusing on the spendable, after-tax measurement.  If you want to buy something with your $100k IRA, you must pay taxes on the withdrawal at your current marginal tax rate (which the Roth conversion already did), so one could argue that your break-even occurs on day one after the conversion.  Yes, there can be penalties for early withdrawals in both cases, but we can assume those cancel each other out.

Key Roth Metric

Rather than focusing on a break-even, we should be comparing the family’s long term after-tax net worth estimates, using sophisticated projection software that calculates future tax liabilities as accurately as possible.  With Roth strategies, a key metric is your current vs. future marginal tax rate(s), which is the tax rate that applies to the last dollar of income for the year (depending on whether it is ordinary/earned income vs. long-term capital gains).  This rate comparison, however, does not tell the whole story.

There can still be a little arbitrage even with equivalent brackets now vs. in the future.  If $25k covers the full tax on a conversion now, and I don’t convert, that $25k has to be invested and grow to cover the future taxes on my required minimum distributions (RMDs) in retirement, since the IRA and associated tax liability has grown, in order to be equivalent.  That growth, however, will have capital gains tax, which means there can be an advantage to converting now. 

Understanding the Roth rules is a good starting point, but it’s not very useful if you do not have proven, thoughtful methods for applying that knowledge in a way that maximizes your after-tax net worth.  This article does not provide specific methods, but it does provide some background knowledge that can help you determine if your advisor/CPA is capable of applying sound methods. 

For those short on time or attention span, here are your shortcut vetting questions:

Ask your advisor/CPA:

• “What are the estimated changes in after-tax net worth for my family long-term if I convert $10k less and if I convert $10k more than your recommendation and why?  What future estimated marginal tax rates are you applying during my retirement and how are those determined?” 

 

For the Roth 401k/IRA vs. traditional 401k/IRA contribution decision:

• “What is the estimated change in after-tax net worth for my family long-term if I contribute to a Roth 401k/IRA instead of the traditional options?  Does it make sense to stick with one or the other indefinitely or are there years where I should switch temporarily and why?  What future Roth Conversions are being assumed?” (and refer to the prior bullet above)

 

For the champions of delayed gratification out there who want more, here are some of my favorite tax quotes to get you in the mood:

• “The difference between death and taxes is death doesn’t get worse every time Congress meets.”  -Will Rogers
• “This is too difficult for a mathematician. It takes a philosopher. The hardest thing in the world to understand is the income tax.” – Albert Einstein
• “..the reality is there’s no way you can possibly deliver the best possible advice to clients if you don’t know the rules of the game. It would be like trying to play poker without knowing that three-of-a-kind beats two pair. Sure, you can win a few hands thanks to good old fashioned luck, but if you play enough hands, you’re almost certainly going to be a loser.” – Jeff Levine

 

Backdoor and Mega Backdoor Roth conversions, with the proper set-up, do not require much analysis.  You typically just convert 100% of the after-tax balance.  When we are talking about converting pre-tax balances from traditional IRAs, 401Ks, etc., however, you will find a wide variety of answers.

Many advisors and financial planning software programs will show the projected benefit of converting to the top of your current marginal tax bracket.  This might be helpful, but narrow-focus analysis will result in less tax savings.  Be wary of low-sophistication software and advisors without much tax expertise, which can result in:

• Significant money being “left on the table.”  You and your heirs could be exposed to unnecessary overpayments to the IRS during your lifetimes.
• Outcomes which are worse than if you never executed the conversion.  A Roth conversion or Roth 401k/IRA contribution rather than traditional is a bad idea for some individuals, depending on their specific situation. 

 

I’m going to address Roth conversions below, but the detailed analysis needed to optimize the conversion amount is very similar to the analysis needed to address the Roth 401K/IRA vs. Traditional 401K/IRA contribution choice. 

Depending on your situation, the present value of the potential tax savings from a quality Roth conversion strategy can be well into the 7 figures (and it can provide tax “insurance” against exposure to the single filer brackets when a spouse passes away prematurely).  Failure to calculate the right amounts to convert each year, however, can significantly lower that benefit.  A small investment of time and focus now with a qualified expert can pay big dividends later.

The key to a successful conversion is converting pre-tax assets at a lower tax rate than the future tax rate that will apply to the withdrawals on those assets.  Even if your rates stay the same, there’s a good argument for converting since the invested funds that will pay the future taxes will likely be exposed to capital gains tax. 

Future Projection Modeling

Modeling out future projections is crucial for this analysis, but you have to keep in mind that the future income levels do not tell the whole story.  Factors such as Social Security benefits taxation, the Medicare/net investment income surtax, Medicare premiums, Qualified Business Income (QBI) deduction limitations, and long-term capital gains can affect the future, true marginal tax rate.  If retirement plan assets will be going to heirs, then their expected tax brackets should be considered as well.  They might be pushed into higher brackets with the requirement to liquidate inherited accounts within 10 years of your death. 

Would conversions this year result in future exhaustion of your after-tax accounts (cash and non-retirement accounts), forcing you to pull high amounts from your IRA in the future and pushing you into the higher brackets?

This may sound complicated, and it can be tempting to just say that since we don’t know where tax rates will be in the future, we don’t need the analysis headache involved with truly optimizing a Roth conversion.  To each his own, but keep in mind:

• The investments analysis world seems incredibly tolerant of complexity, and their targeted advantage/alpha margins are typically much smaller than the payoff from a quality Roth conversion or 401k/IRA choice analysis.  And I don’t think I’m going out on a limb by saying that stock market predictions are generally much less accurate than future tax rate assumptions.
  • If we applied the same level of effort to capture tax “alpha” (the increased value from applying lifetime tax reduction strategies) to the investment world, the active investment analysis industry headcount would probably be less than 10% of today’s level.
• We know that tax rates are scheduled to go back up in 2026, and Biden wants to apply tax hikes sooner rather than later.  
• The national debt is high and going higher.  That typically means future tax hikes.

 

Here are some questions you can ask your advisor or CPA to get an idea of whether their Roth conversion analysis is sound or flawed:

• Why are you recommending I convert $X this year?  What happens to the after-tax net worth for my family long-term if I convert $10k less or $10k more and why?
• Are you factoring in conversions for multiple years, and what methodology is being applied to determine how that is split up?
• Are future optimized Roth Conversions applied to the projections before comparing Roth 401k/IRA to Traditional 401k/IRA?
• Are the potential increases to Medicare premiums due to the conversions being applied?
• Is there a report that breaks out the taxable items and how does it compare to your last tax return?
• If you might move to another state, is that scenario being provided, including the change in taxes?
• Ask to see the reports that show the change in Taxable Income and Taxes.  Does this correlate with the Roth conversion amount being recommended?  If not, the software may be applying some type of proration, which can become more of an issue later in the year.  Are they applying a workaround if the software has limitations in this area that they can show and explain to you?
• Have they discussed applying a 60-day rollover strategy to address the risk of a value drop in the first 60 days after conversion?
• Are the “tax drag” settings (turnover, dividends vs. interest, etc.) for your non-retirement accounts realistic?
• Are the tax/cost basis settings accurate for each non-retirement account?
• Is the Roth allowed to grow without distributions until death, or does it make sense to use it for spending in certain years?  How are they determining this?
• Are potential future Estate Tax liabilities being addressed?

 

A conversion and/or Roth 401k/IRA switch will likely reduce an advisory firm’s revenue, and the associated analysis can be a large expense for the firm, but there are still many examples of firms doing the right thing with pro-active, precise Roth strategies.  If you work with an advisor/CPA who can generate robust projections that address these concerns (or if they partner with someone who can), then you are ahead of the game and your family will likely pay much less in lifetime taxes. 

Some CPAs are providing these services, but most are focused on tax savings for the prior year, this year, and maybe a few years out.  Most do not attempt projections that cover the rest of your life (which is needed), but there’s a good reason for this: Clients do not ask them for that type of analysis, and/or they don’t want to pay them for it. 

Financial Advisors have jumped on that role, and this is a generally a good thing.  I think, however, we need to have some type of oversight, testing, and auditing of the advisors who create and present these projections and base their recommendations on the output…but don’t hold your breath.  Competent use of financial planning projections can be compared to racing and maintaining a Formula 1 car.  It requires a lot of practice and planning/tax knowledge to operate proficiently, and small mistakes can result in large misleading changes to the outcomes and recommendations. 

Focusing on these projections can feel ominous and stressful for some, but it might be helpful to keep in mind that delayed gratification pays off with this effort.  The brief amount of time spent vetting your advisor and their analysis can result in significantly improved future financial outcomes…and additionally, Einstein would be impressed.