IRA to Roth Conversions

Economics, Politics
by Mike Clements

Introduction

An IRA is a savings account with privileged tax status. There are essentially 2 kinds:

  • Traditional IRA: taxes are deferred. Contributions and growth are not taxed. Distributions are taxed as income.
  • Roth IRA: taxes are paid up front. Contributions are taxed as income (made from after-tax dollars). After this, no taxes are ever due again. Growth and distributions are not taxed.

Henceforth, the term “IRA” will mean a traditional IRA.

An IRA takes several forms (such as 401K) and anyone can contribute to them. A Roth is more restricted – people who make too much money cannot contribute to them.

A Roth conversion means moving money from an IRA to a Roth. Anyone can do this, at any age. Even if you are young enough that you would pay penalties for taking distributions from your IRA, those penalties don’t apply to Roth conversions. Even if you make too much money to contribute to a Roth, you can still convert IRA to Roth. For tax purposes, a Roth conversion is treated like any other IRA distribution: the money is taxed as income and adds to any other income you may have.

One important aspect of this discussion is the RMD: Required Minimum Distribution. Starting in your 70s, every year you must take distributions of around 4-5% of all of your IRAs, whether or not you need the money. This is how the government ensures they will get the taxes that have been deferred for years.

One might ask, “Why is this a problem, since you intended to use that money for retirement anyway?” And the answer may well be that it’s not a problem. Yet it may become a problem if you saved so much money that the RMDs force you to withdraw more than you need. And since it’s all income, due to progressive income brackets, taking a little more money than you need can mean paying a lot more taxes.

Why Convert?

Death and Taxes are inevitable and inescapable. Neither IRAs nor Roths are tax-free but they are taxed differently. People convert IRA to Roth for many reasons, but they all boil down to tax optimization in one form or another.

Multiplication is Commutative

Multiplication is commutative, so if your future tax rate is the same as today, there is no difference between a Roth and a traditional IRA.

Put mathematically, suppose you have

  • P = $100k, the princpal you have invested
  • G = 6%, the expected return on investment (CAGR = compound annual growth rate)
  • T = 15%, your expected tax rate
  • Y = 20, or number of years you are comparing

Then the future value of investments

  • The after-tax value of a traditional IRA is P x (1+G)^Y x (1-T)
  • The after-tax value of a Roth IRA is P x (1-T) x (1+G)^Y

All we have done is re-order the terms. Multiplication is commutative, so the result is the same:

  • IRA: 100,000 x 1.06^20 x .85 = $272,606.52
    • You invest $100k pre-tax, it grows at 6% for 20 years, afterward you pay 15% on it when you take it out.
  • Roth: 100,000 x .85 x 1.06^20 = $272,606.52
    • You pay tax on $100k and invest the remaining $85k, it grows at 6% for 20 years, afterward you take it out tax free.

Marginal Tax Rates

Every dollar converted to Roth is “income” on top of the normal expenses you are already paying, and the US income tax brackets are highly progressive. Thus Roth conversions are taxed at your marginal (highest) tax rate, and they can also kick you up into higher tax rates.

For example, your normal cost of living might put you in the 12% or 20% tax bracket. But that doesn’t mean you’ll pay that same rate on Roth conversions. They can kick you up to higher tax brackets unless you plan carefully and limit the amounts you convert.

Present vs. Future Value

The present future value of money is often ignored, but it is an important factor. Even if you pay the same dollar amount today vs in the future, it’s more expensive today.

This weakens the case for commutativity. If the tax is the same either way in absolute dollar terms, better to pay incrementally over the next 20 years, than pay up front today.

However, taxes work in percentages. Those future taxes are bigger amounts in absolute dollar terms even if they are the same percent of a bigger number. And vice versa: when you pay taxes up front with Roth, you pay on the money before it grows from investment so the same percentage is a smaller sum of money – you forego the earnings those taxes would make.

For example, consider the above commutativity analysis. The Roth has $15,000 in taxes while the  IRA has $48,107. It seems the Roth is far better with less than 1/3 the taxes. But the Roth taxes are paid up front while the IRA taxes are deferred for 20 years. That $15k grows to exactly $48,107 over 20 years. So these amounts are exactly equal considering the present vs. future value of money.

The overall impact is that Roth conversions are not as advantageous as they appear at first glance because the taxes are paid up front with present money. Even if you pay less in absolute dollar terms, they are “bigger” dollars worth more today than they would be in the future. Roth conversions still may be advantageous despite this (or not). To determine this, the comparison must consider the big picture with compounding interest and inflation.

Annual Average Tax Rate

Using annual average tax rates is misleading because the income amounts aren’t the same every year. To make it realistic you’d have to compute the income-weighted averages of each year.

Here’s an obvious example to illustrate the point: suppose you have an IRA worth $1M and your cost of living is $85k per year.

Case 1: you convert in a single year and due to progressive income tax brackets, this has an effective overall tax rate of 30% or $300k. This leaves $700k remaining which will last for just over 8 years. Your tax rate is 30% in the first year then zero for the next 7 years. The average of (30, 0, 0, 0, 0, 0, 0, 0) is 30 / 8 or 3.75%. But you paid the 30% on a huge amount ($1M), and the 0% on only $85k each year.

Case 2: you take $100k per year paying 15% on it. It’s only 15% instead of the 30% above because income tax brackets are progressive and this is a smaller amount. That’s 15% every year, so your annual average tax rate is 15%. That’s 4 times higher than the above 3.75%! But it’s applied to smaller amounts so you actually pay less tax and keep more of your money. After 8 years you still have $200k or just over 2 years of money remaining. Even though your annual average tax rate was much higher, your actual taxes were lower and your money lasted a few years longer.

If you compute the income-weighted annual average tax rate, it is the same as computing the total tax paid: $300k versus $150k. This is on the same total amount, so you doubled your taxes by converting all at once. And due to present vs. future value it’s even worse than that, since you paid $300k up front to avoid paying $150k over 10 years.

Total Value vs. After-Tax Value

The total value of IRA vs Roth accounts is often compared, which is misleading because it is the after-tax value of accounts that matters. This applies not only to you during your lifetime, but also to those who will inherit your money.

Simply put, if you have $1M in a traditional IRA, it’s not entirely yours. The government owns a portion of it through taxes. If you have $1M in a Roth IRA it is entirely yours and thus worth more. Of course, it cost you more to get $1M into a Roth than $1M into an IRA, since you paid the taxes up front.

People who inherit an IRA typically have 10 years to liquidate the account and pay income taxes on it. If your inheritors are adult children, they may be in the same or higher tax bracket than you are, and thus pay more taxes on that money than you would have.

Taxes are Interconnected and Complex

Our tax system is so complex and parts of it are so ambiguous, even accountants, lawyers and the IRS sometimes disagree on what it means. The cynical among us would say this complexity and ambiguity is a “feature” not a “bug”, as it gives the IRS flexibility in interpretation for selective enforcement or to bully or threaten taxpayers. However, one doesn’t have to be cynical to understand that the tax code is complex enough to make it difficult even to comply, let alone to optimize.

Income tax brackets are progressive, and other kinds of taxes such as Social Security, Medicare and long term capital gains have different rates that depend on each other, based on several different definitions of AGI (adjusted gross income) and MAGI (Modified AGI). Furthermore, some investments have returns that are impossible to predict, and even if you could predict them you still couldn’t predict how they impact your taxes.

For example, suppose you own shares of an index fund in a brokerage account. That fund has capital gain distributions that depend on turnover within the fund to track the index. This level of turnover depends on how different stocks increase or decrease in value which is unpredictable. And whether those gains are long or short term is also unpredictable. Furthermore, some of the stocks in the fund’s index pay dividends. The balance of funds changes, and companies change their dividend payments, so you can’t predict how much dividends you will get. And you can’t predict how much of those dividends are qualified (thus taxed as capital gains) or non-qualified (thus taxed as income).

Another example: you decide to do Roth conversions to fill the 22% tax bracket, which in 2025 has an upper limit of $206,700. Due to the standard deduction of about $30k, you actually take $236,700 to hit that limit. But that’s above the Medicare IRMAA threshold, so it triggers more taxes there. And you were meeting your cost of living by selling taxable brokerage investments, which would have had no tax because your income would have been below $100k after deductions, but the Roth conversions raised your income so now you owe 15% on those. But wait, the dividends on your brokerage account took your MAGI high enough that you also pay the NIIT of 3.8%. And because your income is so high, you also end up paying taxes on your Social Security. That’s 4 nasty surprises springing from not understanding the interconnected complexity of our tax code. The Roth conversion you think is optimal may trigger a “tax tornado” that makes it counterproductive.

Another fact: if you’re younger than 59 1/2, you pay a penalty for any IRA withdrawals that you don’t transfer into a Roth. This means if you withhold taxes from the IRA distribution that you convert, you’ll pay a penalty on that portion of it! For example, suppose you convert $10k in the 20% tax bracket. You’ll owe $2,000 in taxes. If you take $12,500 from the IRA to put $10k into a Roth and withhold the remaining $2,500 (send it to the IRS), they will charge you a $250 penalty, which is 10% of the amount you took out of the IRA and didn’t put into a Roth. The only reason you didn’t put that $2,500 into a Roth is because you sent it to the IRS, but they don’t care and that doesn’t matter. The better way to do this is take only $10k from the IRA and convert to the Roth, then pay the $2,000 tax from other funds. This saves you $750!

What makes matters worse is that many of the tools people use to plan retirement don’t account for all of this complexity, so they end up making bad suggestions, usually erring on the side of conversions that are too big and trigger nasty tax surprises.

Decisions and Scenarios

Due to the above factors, some people make ill-advised or sub-optimal Roth conversion decisions.

Some Roth conversion scenarios are easy no-brainer decisions:

  • You are certain that your taxes today are lower than they will be later.
  • There are several variations of this, and here is a common one: You retire early and live from after-tax investments. For the next few years, you have no “income”, but only long term capital gains, which are taxed at lower rates, and you could have a zero tax bill. You know that you will have “income” in the future, whether you want it or not – Social Security, RMDs, pensions. That income stream will raise your tax rates so now is the time to convert IRA to Roth while you’re in the lowest tax bracket.

Some Roth conversion scenarios are more speculative or subjective.

  • You believe that tax rates must inevitably increase in the future, due to today’s historically high levels of government debt.
  • You want your inheritors to get your estate free and clear, without burdening them with taxes that may be even higher than you would have paid if you had lived longer.
  • You want the satisfaction or confidence of knowing your future retirement will be tax-free and you’re willing to pay up front for this even if it ultimately costs you more.

Some Roth conversion scenarios are just a bad idea:

  • If your entire savings is in IRA accounts, you have little to gain and much to lose from Roth conversions.
    • While working, any amounts you convert add on top of your salary and are taxed at the highest marginal rates – higher than you’d pay if taking those distributions in retirement.
    • After you retire, any amounts you convert add on top of whatever you take to meet your cost of living, so the same applies – it’s like inflicting RMDs on yourself early and unnecessarily.

Conclusion

Roth conversions can be a useful tool to reduce taxes but they aren’t for everyone. Getting it wrong can can trigger a tax tornado. It seems to me that everyone is talking about Roth conversions, but they are rarely beneficial for most people. Before making Roth conversions, don’t make some of the common mistakes mentioned above, but do make sure you understand your reasons for doing it and the full tax implications across all sources of income.