Roth conversions could offer more value than your clients expect

This article was updated on September 8, 2022

Your clients have most likely funded their traditional IRAs for years, if not decades. And they have probably built up a substantial balance in those tax-deferred holdings. But as you know, financial situations, tax brackets, and tax laws change over the years. Your clients' required minimum distributions (RMDs) are not only taxable, they could be quite large and push your clients into higher tax brackets. One way to potentially reduce your clients' tax burden in retirement is to consider converting their traditional IRA to a Roth IRA.

As your clients approach retirement, exploring the tax advantages of a Roth IRA is the perfect opportunity to have a conversation, especially if clients expect their future tax rate to be higher than their current one.

Here's how it works: Client assets are transferred from a traditional IRA to a Roth reasonably quickly, but the typical holdup is the tax bill due at the time of conversion. Since traditional IRA assets have been tax-deferred, taxes are due at the time of conversion, and a large tax bill isn't something many clients will be eager to pay. However, these concerns may be overblown in many instances when clients consider their break-even tax rate (BETR).

Explore the benefits of a Roth conversion

Roth IRAs have several advantages over their traditional counterpart:1

• No required minimum distribution—You can guide clients on when and how to withdraw funds.
• Tax-free growth—All investments in the account grow free from taxation.
• Tax-free withdrawals— After age 59½, clients can tap the account without fear of tax or penalty. Basis can also be withdrawn at any time.
• Social Security and Medicare flexibility—Doing a Roth IRA conversion before claiming Social Security and Medicare is beneficial, because future distributions from Roth won't impact the tax implications of Social Security and Medicare surcharges.
• Variety of accounts—Having multiple buckets to withdraw from provides additional tax planning benefits.

Many of your clients may understandably still underestimate the perks that a Roth conversion can provide since they must pay a significant tax bill upfront for the transfer. By taking the break-even tax rate (BETR) into account, clients can be shown how Roth conversions are more beneficial than conventional wisdom suggests.

Use the BETR calculation for more effective planning

The conventional approach is relatively straightforward. Calculate a client’s future expected tax rate at the anticipated time of withdrawal and compare it with their current expected tax rate. If current rates are lower, the conversion makes sense. If current rates are higher, keep the assets in the traditional IRA.

The BETR could be a more effective calculation than simply comparing future and current tax rates.  The BETR is the point at which after-tax withdrawal values are the same whether you convert or not and knowing this break-even point could show that a conversion is beneficial in more instances than relying on the conventional comparison between future and present tax rates alone.

Using the BETR takes more data into the equation, such as:

• Ability to pay conversion taxes from an outside taxable investment account.
• The tax basis of the IRA account. A market pullback is often the best time to make a conversion since reduced capital gains means a lighter tax bill.
• Potential future contributions to the IRA account, like backdoor Roth conversions.
• Client time horizon (a longer time horizon reduces BETR and makes conversions even more attractive).

When paying conversion taxes from funds in a taxable account, the BETR approach shows that conversion may be beneficial even if future tax rates are expected to be lower than current rates. Your clients will maximize the assets growing tax-free in the Roth IRA by using taxable funds to pay the conversion tax.

The three scenarios shown in the figure below differ only in the account from which Roth conversion taxes are paid. Each assumes a 35% current marginal tax rate. In Scenario 1, conversion taxes are withheld and paid from the IRA (we assume that no tax penalties are incurred for early withdrawal). In Scenarios 2 and 3, these taxes are not withheld during conversion. Instead, they are paid separately, from either a tax-efficient portfolio in a taxable account (Scenario 2) or a tax-inefficient portfolio in a taxable account (Scenario 3).

While having some funds in traditional and Roth IRAs can be beneficial, help your clients understand a Roth conversion's benefits. A Roth IRA is a unique account that your clients can use to reach long-term goals beyond just funding retirement, such as estate planning. Having you as their advisor to discuss these strategies with will provide clients with peace of mind.

1 Withdrawals from a Roth IRA are tax free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both. (A separate five-year period applies for each conversion and begins on the first day of the year in which the conversion contribution is made).

Notes:

• All investing is subject to risk, including the possible loss of the money you invest.
• Neither Vanguard nor its financial advisors provide tax and/or legal advice. This information is general and educational in nature and should not be considered tax and/or legal advice. Any tax-related information discussed herein is based on tax laws, regulations, judicial opinions and other guidance that are complex and subject to change. Additional tax rules not discussed herein may also be applicable to your situation. Vanguard makes no warranties with regard to such information or the results obtained by its use, and disclaims any liability arising out of your use of, or any tax positions taken in reliance on, such information. We recommend you consult a tax and/or legal adviser about your individual situation.