Top 3 Roth Conversion Myths - And How to Dispel Them

Roth conversions are gaining in popularity, and with the debate over extending the Tax Cuts & Jobs Act in full swing in Washington, taxes in retirement are on a lot of savers’ minds.

But many savers still believe some common myths about converting traditional funds to tax-free Roth accounts. Here are the top three myths I hear - and why we need to dispel them for our clients.

Myth #1: Roth Conversions are Expensive! Who Wants to Cut a Check to the IRS?

For many people, the immediate and deal-killing objection to a Roth Conversion is paying taxes upfront. Yes, when converting IRA assets, you are subject to the painful action of writing a check to the IRS. And for wealthier clients, the tax bill can be large.

What many people fail to realize is that’s the point. The point is, believe it or not, to pay the IRS. Why? Because IRA money will eventually be taxed as income - to the IRA owner or their heirs. A Roth Conversion allows savers to give the IRS their cut today rather than letting the account grow and giving the IRS their cut in the future.

So why cash the IRS out now? Because for many of our clients, there’s a real risk taxes could be higher in the future than they are today. Therefore, cutting a check to the IRS is essentially paying your taxes at a discounted rate.

Here’s the reality: If we agree that all IRA assets will eventually be taxed, then we need to take the step of looking at all IRA balances with an after-tax view. When it comes to after-tax dollars, savers have the same IRA balance before and after the conversion (assuming they convert funds at their current marginal tax rate). This is how our clients should be thinking: in terms of spendable income.

In that way, we’re not really creating a tax bill by converting funds to a Roth account. We’re giving the IRS their portion at a time most beneficial to our clients. When you look at a Roth Conversion through the lens of lifetime taxes in retirement, savers should be excited to write that check to the IRS.

Myth #2: Converting will Push You into a Higher Tax Bracket. That’s Bad! 

Conventional wisdom suggests that savers should only convert up to the threshold of their existing tax bracket. In this way, the saver can avoid paying additional taxes that would be owed on income from the conversion that pushes them into a higher tax bracket.

And for many savers, this is the way to go. However, we shouldn’t assume this is universally true. And to understand why, we need to understand two concepts.

First, Conversion Delta. Conversion Delta occurs when taxes change during a saver’s projected conversion period. For example, let’s say you’re converting up to your existing bracket, and that means it will take ten years to complete your conversion. What happens if taxes rise by 20% in year 5? Conversion Delta is the amount of extra conversion tax a saver would pay because of a tax increase during the conversion period. In this example, a client may have been better off completing the Roth Conversion before taxes changed.

Second, Tax Drift. Tax Drift occurs when the additional funds from a client’s conversion push them into a higher tax bracket. The “drift” in this case is the additional taxes they’ll pay on the portion of their income in the higher tax bracket. But in some cases, a little tax drift might be worth it to offset the increased Conversion Delta.

Additionally, for many savers, the tax savings of a Roth Conversion far outweigh the tax cost of Tax Drift.

The key is to analyze total taxes (and government fees like IRMAA) on the conversion and make sure the client is happy with the approach. (Stonewood Financial has new software coming out this month that performs this analysis at the push of a button. Click here to set up a call, and my team will show you how it works.)

Myth #3: A Break-Even Analysis is the Most Important Roth Analysis

Too many savers - and some advisors, too - believe the most important analysis is a break-even analysis on the *entire* conversion amount. But oftentimes, this kind of analysis can be misleading.

Between common assumptions our clients make and the math that follows from them, it becomes clear why the break-even analysis is a myth. In fact, based on these assumptions, the breakeven point is day one.

So what are the common assumptions our clients tend to make?

• The account will have the same growth rate whether the assets are converted or not. So the growth rate is neutral to the example.

• The tax rate applied to conversion assets is the same tax rate that would be applied to future distributions. So the tax rate is also neutral. (For a deep dive into this math, check out my blog post, Are Roth Conversions Worth It?)

In some cases, the tax rate may not be the same. For example, if we do assume some tax drift during the conversion, the saver would be paying a higher percentage on the converted assets than they would through future distributions. However, it also might work the opposite way. If taxes rise in the distribution phase (which for many savers is the reason for the conversion discussion), then the saver would potentially pay a higher rate in the distribution phase.

Now, for many conversions, this is a small amount. You must remember the progressive tax system in our country. Only assets above the threshold pay the higher tax percentage. But to be fair, there may be cases where some extra tax is paid from this tax drift. And that amount is what should be subject to this break-even discussion. 

(One notable exception, of course, is if all funds being considered for the conversion are going to charity.)

The true takeaway should be that the only amount you should consider for a breakeven analysis is the additional tax driven from crossing the threshold of a new bracket. This is the analysis number that actually matters - and that can drive the decision to convert or not to convert.

Dispelling Roth Myths

In the end, many clients need a more complete Roth analysis to know whether a conversion makes sense. Stonewood has new software to help advisors like you analyze Roth conversions in terms of total taxes and fees paid - both if the client converts and if they stay in their traditional account. We’d love to show you how it works - you can schedule a call here.

Let me know your thoughts in the comments. Are there any ways you’re overcoming these myths? Are there any myths you think I missed? We’ll cover them in future posts.