When’s the Best Time to Do A Roth Conversion?
By Dave Denniston, CFA
Now, you’re convinced!
Now you know a Roth Conversion is a good thing to do…
The question becomes--- when should you do a Roth conversion?
Is there an optimal time to do it?
Let’s explore when it might be the best times to do a conversion.
How to Time Roth Conversions
There’s really three different factors to consider with the timing of Roth conversions:
- Your income and the tax that you pay
- Your age
- Where the market is
More About Income and Taxes
Some people make a plausible argument that tax rates are incredibly low right now and it’s an incredible time to take advantage of historically low tax rates.
Check out this graph below from the Bradford Tax Institute:
Just taking a quick glance at this graph, you’ll note that we aren’t quite at the lowest rates. The late 1980’s saw even lower tax rates than we see now.
However, we are certainly far below the income tax rates of the 1940’s through 1960’s.
With a sunsetting of the Trump tax cuts, our chronic deficit spending, and a rising tide of baby boomer utilizing social security and medicare that isn’t fully funded, it’s understandable that many folks would prognosticate that higher income tax rates are coming.
Perhaps right now is a good time to do a Roth conversion.
However, I would point back to that it depends on our income bracket.
Let’s take a look at the 2021 tax tables.
Remember from the last article, this table:
Married filing jointly and surviving spouses
0 to 19,900
19,901 to 81,050
81,051 to 172,750
172,751 to 329,850
329,851 to 418,850
418,851 to 628,300
While it is true that the highest tax brackets may rise, there are plenty of other brackets.
I would argue that most high earners who are currently earning more than $330,000, aren’t likely to keep earning that amount of money in retirement.
Could the 10% bracket or the 12% bracket increase to 32% or 35% or 40%?
In my opinion, no. I don’t think it’s likely or even probable. Is it Possible? Yes. But it is still extremely unlikely.
It’s far more likely the lowest income brackets stay low.
If your pre-tax income is $100,000 or less, that is the IDEAL time to do a conversion.
I believe that for many folks the BEST timing is in 2 situations:
- When you have lower income in your working years
- One or both spouses being laid off
- Taking a year off from work
- Going back to school and getting more education
- When you have retire or have lower income in retirement
- Optimal age of 55 to 64 BEFORE Medicare
- Cautiously possible in ages 65 to 70 DURING Medicare, but before you have started social security
However, as usual there are EXCEPTIONS to these generalities. There are some cases where perhaps your retirement income might equal or be close to your working year’s income.
- You are a firefighter or paramedic or public servant of some sort who was earning $100k plus a year while working and now you’ll be getting paid $70k or $80k or $90k in pension income PLUS your social security income.
- You are a corporate executive or manager who has vested stock awards and options that you can exercise IN retirement.
- You have deferred compensation that will be paying you a pension-like income over the first 4 or 5 or 6 or 7 years of your retirement
In these cases, you could easily make an argument that your tax brackets may not be changing much!!
Thus, you might as well convert some money to Roth right now to avoid high RMDs once you hit 72.
Where the Market Is
One of the BEST times to do a Roth Conversion is at an opportune time in the market.
Now, we don’t know when that may be for sure. Check out this blog post…
Here are some of the lessons I learned from my research:
- For the most part, the best time to do at least part of the conversion is at the start of the year
- Should we get a -10% correction, this is a fantastic time. It happens 60% or about 6 out of every 10 years. That’s better odds than a flip of the coin.
- Should we get a -20% bear market, this is an even better time! However, it only happens 25% of the time or about 1 out of every 4 years. If it happens, take advantage of it!
- Should we get an even deeper -30% bear market (like in 2020) and your portfolio is mauled to shreds, do a conversion now!!! That’s assuming that it makes sense tax wise of course. This happens very rarely--- only about 1 out of every 10 years.
Why do I make these suggestions?
Imagine if your portfolio in your pre-tax IRA was worth $100,000. A really bad year happens with a -30% rate of return and now it’s down to $70,000.
What happens if you converted all $70,000 from IRA to the Roth?
First of all, you are converting a much smaller amount of money then it was previously.
Now, you are only paying taxes on a conversion of $70,000 rather than $100,000.
If you’re in the 25% tax bracket, that’s like saving $7,500 on taxes and NEVER having to pay that ever again.
On top of that, imagine what could potentially happen with the portfolio’s growth.
After a couple of years of market rebound, maybe that $70,000 turns back into $100,000.
Let’s say that you don’t need that money any time soon. You can still let it grow and grow over the next 10 to 20 years before you need it.
Let’s also say that you average a 6% annual compounding rate of return over that time period.
Fast forward 10 years and that $70,000 that turned back into $100,000 is now worth…. $179,084.77.
Since you converted it to the Roth --- that money is ALL tax-free.
What if you didn’t need the money for 20 years?
Fast forward 20 years and that $70,000 that turned back into $100,000 is now worth…. $320,713.55.
If we isolate just that $30,000 difference (between $70k and $100k) compounded over 20 years, that money alone becomes worth $96,214.06.
That’s a huge difference in your balance in your Roth. Heck, you just about doubled your initial $100k investment.
More about Age as a Factor
Now, remember how earlier I mentioned that an early retirement was ideal (55 to 64) to start doing Roth conversions?
Let’s dive more into that.
Let’s take a look at how Medicare and something it calls “IRMAA” can impact some couples in the go-go years and beyond.
First, what is IRMAA? It stands for “Income-Related Monthly Adjustment Amount.” The emphasis is on “income” because it is a monthly tiered surcharge (again, a kind of tax) that is tacked on to people’s Medicare Parts B and D premiums. But it only happens if you have income over $87,000 for singles and $174,000 for married couples. Let’s take a look at what this means in action.
Meet George and Martha. They are a high-earning married couple, and both are Medicare Part B and D participants. IRMAA surcharges affect income from two years prior, and this couple was on track for $271,500 of modified adjusted gross income, or MAGI, in 2018.
But on December 1, George decided to sell a stock he bought for $10,000 on July 1, 2007. He sold the stock for $11,000. The resulting $1,000 of gain was taxed at the 15% long-term capital gains rate, plus an additional 3.8% net investment income surtax for a total federal tax bill of 18.8%. (That 3.8% net investment income surtax is another tax that comes into play when your MAGI exceeds $200,000 for singles and $250,000 for married couples.)
So, George and Martha owe $188 of tax on the gain from their sale of the stock, right – 18.8% of $1,000. Or do they?
Look at this Part B IRMAA chart.
That extra $1,000 gain pushed their AGI into the next premium tier that starts with $272,001.
So now, instead of owing $289.20 each for their monthly Medicare Part B premiums, George and Martha will each owe $376 per month, an extra $86.80 per month, times two ($173.60), for an annual total in Part B premiums of $2,083.
Bottom line here--- once you are 65 and pulling benefits from Medicare….. if you are single and can keep your AGI below $87,000 OR if you are married and can keep your AGI below $174,000, then Roth conversions are a wonderful thing to do!
You definitely need to be very wary of doing conversions for anything above those 2 thresholds!!
Converting pre-tax 401k/IRA dollars to Roth IRAs can be very, very powerful.
I will say to you- if you’ve made it this far, you’ve already won! If you have a few million in assets, you’ve done a wonderful job of saving.
If you haven’t gotten there yet, I hope this inspires you to save more and more and utilize Roth when it makes sense and to examine your situation.
The next question becomes--- what could this scenario look like?
We’ll talk more about this in our next article in the final part of this 3 part series.
Call me at (612) 284-2409 or e-mail me at firstname.lastname@example.org