PRICE Retirement Planning

PERSPECTIVE® ROTH CONVERSION STRATEGIES

February 2018

In-depth analysis and insights

TO CONSIDER
to inform your decision-making.

EXECUTIVE SUMMARY
■■ A Roth conversion moves assets from a Traditional IRA to a Roth IRA. Because
you pay ordinary income tax on the taxable amount converted, the strategy is most
compelling when you pay that tax at a relatively low rate.
■■ Converting assets early in retirement before you face required minimum distributions
(RMDs) can reduce those RMDs (and the risk that they will increase your tax rate).

Roger A. Young, CFP®, ■■ A Roth conversion is also a way to introduce tax diversification to your investment
Senior financial planner strategy, as well as opportunities for favorable asset location.
■■ Drawbacks of a Roth conversion include potential effects of higher taxable income
in the conversion year: a higher tax bracket, increased taxation of Social Security
benefits, an increase in Medicare premiums, and reduced eligibility for college
financial aid.
■■ There are a number of reasons you could be paying taxes on conversion at a
higher rate than when you (or your heirs) would take the distribution.
■■ Even if your tax rate is expected to decrease in retirement, a Roth conversion may
still be advantageous in some situations. It depends on whether you will need the
assets for retirement income and how you pay the taxes upon conversion.

Since 2010, all investors have been are subject to RMDs after you reach
allowed to convert assets from a age 70½. These positives need to be
Traditional IRA to a Roth IRA.1 Because weighed against the tax you pay on the
conversions are not subject to income amount converted.
restrictions, people at any income level
can take advantage of the Roth’s key Deciding whether a Roth conversion
benefit—tax-free qualified distributions.2 makes sense in your situation depends
on several factors, including:
A Roth conversion provides you with tax
diversification in your retirement years. In ■■ Your current and future tax rates,
addition, Roth IRAs do not have required
minimum distributions (RMDs) for the
■■ Your mix of assets, and
original owner, whereas Traditional IRAs ■■ Possibly your heirs’ future tax rates.

It may also be possible to convert assets from pretax to Roth within a retirement plan such as a 401(k). While
1

many of the planning principles are the same, this paper focuses on conversions of IRAs.
2
Generally, a distribution is qualified if taken at least 5 years after the year of your first Roth contribution and
you’ve reached age 59½.
Before you execute a Roth conversion, DISADVANTAGES OF CONVERTING TO You could also pay the tax using
you’ll also want to consider: A ROTH distributions from the Traditional IRA
The key disadvantage of a Roth or from existing Roth assets. In both
■■ How you will pay the taxes on conversion is taxes due on the converted cases, you could pay a penalty on the
the distribution, value. There are a number of reasons distributions if you’re under age 59½.
your tax rate may be lower when you (or Funding the tax from a Traditional IRA
■■ Timing of the conversion in relation to would incur ordinary income tax on that
your retirement horizon, and your heirs) take distributions:
distribution, so unless you’re in a low
Many people have lower income tax bracket, that’s not ideal. Using an
■■ Whether you are planning to use the ■■

in retirement. existing Roth to pay the taxes doesn’t

money converted or planning for it to
result in ordinary income tax, but this
be used by your heirs. ■■ When you take retirement approach essentially reduces the
distributions, they may represent a amount and the value of the conversion.
ADVANTAGES OF CONVERTING TO
large portion of your income and
A ROTH
straddle tax brackets, resulting in a WHEN IS THE RIGHT TIME TO
You can benefit from a Roth conversion lower average tax rate. (In contrast, CONVERT ASSETS?
by paying taxes now at a lower rate if your the conversion probably adds to
tax rate is likely to be higher when you the income taxed primarily at your A Roth conversion is most compelling
take distributions. The strategy should be marginal, or highest, rate.) when you pay the tax on the amount
considered in a number of situations, if converted at a low rate. So if your
you are able to pay the taxes (preferably ■■ Some states don’t tax retirement income is irregular, consider Roth
from a nonretirement account): distributions, or have no income taxes conversions in low-income years. Or
at all, which is important to consider if you could consider a conversion in a
■■ You expect your tax rate to be higher you might relocate. year when you’ve been unemployed.
when you take account distributions. Unfortunately, those years may coincide
(This could include situations where There are also factors to consider with cash flow challenges, making extra
your current income is unusually low.) specifically for the year of conversion. tax payments impractical. But if you have
Higher taxable income that year could lined up new employment without falling
■■ You plan to leave the assets to have one or more of these negative effects: below a prudent cash level, a conversion
heirs whose tax rates will be higher could make sense.
than yours. ■■ A higher tax bracket,
Another common example is converting
■■ Your assets are primarily in tax- ■■ A higher portion of Social Security assets early in retirement before you
deferred accounts and you want more benefits subject to tax, face required minimum distributions. As
tax flexibility. noted above, be careful about triggering
■■ Higher Medicare premiums, and
higher taxes on Social Security benefits
■■ You want more opportunity to optimize
■■ Less eligibility for student financial aid. or higher Medicare premiums in the
asset location—holding different types
conversion year. However, reducing your
of assets in different accounts.
STRATEGIES FOR PAYING TAXES ON RMDs could have a favorable impact
■■ You want a hedge against higher A CONVERSION on Social Security taxation or Medicare
statutory tax rates. (For example, premiums later. Ideally, you should
In general, a conversion works best if you
following the tax cuts passed in late coordinate your Social Security claiming
can pay taxes from a taxable account.
2017, you might believe that tax rates strategy and retirement income strategy,
Selling assets in a taxable account may
are unlikely to be any lower during including the account drawdown order
be all or partly a return of your principal
your lifetime.) and possible Roth conversions.
(cost basis) and, therefore, not be a taxable
gain. Realized gains from those sales may
■■ You won’t need your RMDs for RUNNING THE NUMBERS—EVALUATING
be taxed at the long-term capital gains
retirement expenses. As we will discuss DIFFERENT SCENARIOS
rate, which is typically lower than your
further, even if your tax rate stays flat
marginal ordinary income tax rate. If you’re We analyzed a situation in which a Roth
or decreases in retirement (despite the
considering this approach, make sure that conversion may make sense: Traditional
RMDs), a Roth conversion could be
you still have an adequate emergency fund IRA assets that won’t be needed for
beneficial if you pay the taxes from an
and that this doesn’t inordinately reduce retirement income are available, and a
account that isn’t highly tax efficient.
your financial flexibility. taxable account exists to pay the tax upon
conversion. In this situation, the assets
are intended to pass to heirs (in the next

P R I C E P E R S P E C T I V E® 2
generation, as opposed to between the date of your death, so those gains are increases during retirement, because
spouses). A person in this position can also essentially tax-free. those are generally advantageous for Roth
use a series of annual Roth conversions conversions. Again, the idea was to depict
to reduce unwanted RMDs.3 Within this For each combination of these a situation in which Roth conversion is
framework, we evaluated scenarios with a parameters, we measured the results of plausible but not a “slam dunk.”
focus on three key parameters: three strategies:
KEY FINDINGS
■■ Tax characteristics of the taxable ■■ No Roth conversion,
account used to pay taxes on 1. In this broad situation (in which
a conversion,
■■ Roth conversions each year from age the IRA assets aren’t needed for
55 to age 70, and retirement spending), the benefit of
■■ Tax rate during working years versus a Roth conversion is driven largely
in retirement, and
■■ Roth conversions each year from age by the profile of the taxable account
65 (retirement) to age 70. being used to pay taxes on the
■■ Potential tax rate of your heirs. conversion. If the taxable account
Each strategy is measured by the total
is primarily generating ordinary
The first of these parameters merits some after-tax asset value received by heirs upon
income or even capital gains, Roth
explanation. Returns in a taxable account the owner’s death (assumed to be age
conversions are usually beneficial in
can generally be treated in one of three 95). This value assumes that Traditional
the general situation we studied. (See
ways for federal income tax: ordinary IRA assets are taxed upon death at the
dark blue and bright blue rows in
income (e.g., interest received), capital heirs’ ordinary tax rate. (Roth and taxable
Figure 1.)
gains (profits from the sale of securities), accounts are assumed to pass to heirs
and tax-free (e.g., interest for certain income tax-free.) 2. There are situations in which a
municipal bonds). In addition, if you hold Roth conversion doesn’t add value.
appreciated securities until death, your We evaluated 12 combinations of (See dark gray rows in Figure 1.)
heirs can benefit from a “step-up” in cost assumptions for the three key parameters. This occurs if the taxable account
basis. That means that they don’t pay Other assumptions were held constant generates tax-free returns and the
capital gains taxes on appreciation through for all scenarios.4 We didn’t analyze person’s tax rate in retirement (and/
situations where the worker’s tax rate

FIGURE 1: TOTAL AFTER-TAX VALUE OF ASSETS TO HEIRS

Value and Percent Difference From the Strategy Without Roth Conversions
Ordinary Tax Rates No Conversion Conversions Starting Conversions Starting
vs. Working Years at Age 55 at Age 65
Tax Profile of Taxable Account Retirement Heir Value Value % Diff Value % Diff
Unchanged Unchanged $4,677,313 $5,359,642 14.6% $4,831,199 3.3%
0% of returns tax-free; 50% subject to Unchanged Lower (22%) 4,696,468 5,364,474 14.2 4,846,885 3.2
capital gains rate; 50% at ordinary rate Lower (22%) Unchanged 4,797,454 5,404,514 12.7 4,944,703 3.1
Lower (22%) Lower (22%) 4,816,609 5,409,346 12.3 4,960,389 3.0
Unchanged Unchanged 5,122,971 5,487,100 7.1 5,204,373 1.6
50% of returns tax-free; 25% subject to Unchanged Lower (22%) 5,142,126 5,491,932 6.8 5,220,059 1.5
capital gains rate; 25% at ordinary rate Lower (22%) Unchanged 5,232,711 5,532,296 5.7 5,311,968 1.5
Lower (22%) Lower (22%) 5,251,866 5,537,128 5.4 5,327,654 1.4
Unchanged Unchanged 5,642,131 5,642,131 0.0 5,642,131 0.0
100% of returns tax-free; 0% subject to Unchanged Lower (22%) 5,661,286 5,646,963 -0.3 5,657,817 -0.1
capital gains rate; 0% at ordinary rate Lower (22%) Unchanged 5,736,266 5,686,392 -0.9 5,739,735 0.1
Lower (22%) Lower (22%) 5,755,421 5,691,224 -1.1 5,755,421 0.0

3
 his analysis builds upon T. Rowe Price’s February 2015 paper by Judith Ward CFP®, “How to Minimize Unwanted RMDs Using a Roth IRA Conversion Strategy.”
T
4
Assumptions for all cases: A married couple has an annual household income of $200,000 and is in the 24% federal tax bracket. The income level is such that
Roth conversions ($40,000 annually during the relevant years) do not change their federal tax bracket. State income taxes are not considered. (This approximately
reflects the state tax rate not changing from working years to retirement.) The couple has $500,000 saved in Traditional IRAs that they do not expect to need for
retirement income. The fact that they have other income sources is important, but the analysis does not need to reflect those assets or cash flow streams. One
spouse contributes $6,500 annually to a Traditional IRA from age 55 until age 65. The couple also has $130,000 in a taxable account that can be used to pay
taxes on the Roth conversion (using assets without gains, so there is no additional tax due to liquidation). This account will also be used to invest RMDs from the
Traditional IRAs (since RMDs are not needed for retirement spending). All accounts have 6% annual investment returns, before taxes. All capital gains are taxed at
the 15% rate. RMDs are assumed to be taxed at the marginal rate (not across multiple tax brackets), which stays steady through retirement.

P R I C E P E R S P E C T I V E® 3
 or the heirs’ tax rate) is lower than FIGURE 2: ROTH CONVERSION EFFECTIVENESS
during working years. Breakeven Point Based on Tax Efficiency of Taxable Account and Amount of Tax
Rate Decrease
3. If converting makes sense, you
generally get much more benefit 100%
by starting sooner (and, therefore, 100

Taxable Account: % of Income Tax-Free

89%
converting more). Alternatively, you Roth Conversion
could convert the same total amount 80 Unfavorable
over fewer years, but you’d be more
60%
likely to jump into a higher tax bracket. 60
Roth Conversion 43%
The importance of the taxable account Favorable
profile may seem counterintuitive. After all, 40
the conversion is from a Traditional IRA
(pretax) to a Roth, and the taxable account 20
seems like a secondary factor. In general,
however, Traditional and Roth IRAs have 0
No Change 24% to 22% 32% to 24% 22% to 12%
equivalent results if a person’s tax rates
stay constant.5 So you can think of a Roth Change in Marginal Federal Tax Rate From Working Years to Retirement
conversion more as a shift of assets from a
taxable account (the conversion tax paid)
to a tax-advantaged one. This explains CONCLUSION For these investors, a Roth conversion
why row 9 of Figure 1 shows no difference
People approaching retirement age or reduces unwanted RMDs. It is especially
between converting and not converting
recently retired should at least consider a attractive if their taxable income is low
if tax rates stay constant and the taxable
Roth conversion strategy. Many of those in their early retirement years. However,
account is all tax-free.
people will correctly conclude that it’s not even if their tax rate stays flat or
practical or advantageous due to up-front decreases in retirement, they may benefit
It may also be surprising that the benefit
taxes on the conversion. from a Roth conversion if they are using
of this shift from taxable to tax-advantaged
a relatively tax-inefficient taxable account
can even outweigh a tax rate reduction
However, our analysis paints a picture of to pay the taxes on the conversion.
in retirement. So we dug a little deeper
people who could benefit significantly. Because there are many interrelated
to analyze the impact of taxable account
These people have saved diligently in factors in this decision, you may want
profiles for different levels of tax rate
all of their pretax retirement accounts. to consult with a financial planner to
reduction (see Figure 2).6
They probably don’t have significant Roth evaluate your specific circumstances.
For example, if a couple’s tax rate falls assets, because Roth contributions were
from 24% in working years to 22% in unavailable or unattractive at their income
retirement, converting is favorable unless level. They have taxable account assets,
more than 89% of earnings in the taxable perhaps from windfalls or because they
account are tax-free. For someone whose were able to save beyond retirement
rate falls from 22% to 12%, converting contribution limits. They may have a
becomes unfavorable when more than pension or other income sources that give
43% of the taxable account earnings them confidence they will leave assets to
are tax-free. Again, these numbers rely their heirs.
on the specific situation evaluated, in
which someone doesn’t need RMDs for
expenses in retirement, among other
assumptions.

5
Kutner, George W.; Doney, Lloyd D.; Trebby, James P. Investment Performance Comparison Between Roth And Traditional Individual Retirement Accounts. Journal of
Applied Business Research (JABR), [S.l.], v. 17, n. 1, Feb. 2001. ISSN 2157-8834. Available at: cluteinstitute.com/ojs/index.php/JABR/article/view/2064.
6
This analysis assumes the taxable account generates only earnings at 0% or capital gains rates, not at ordinary rates. (This reflects a person who carefully
manages assets across account types.) It also assumes the heirs’ tax rate is the same as the person’s tax rate during retirement. Starting amounts in the accounts,
as well as the amount of annual conversions, are adjusted proportionally based on approximate income levels for the starting tax brackets. Other assumptions are
consistent with the analysis summarized in Figure 1.

P R I C E P E R S P E C T I V E® 4
 T. Rowe Price focuses on delivering investment management
excellence that investors can rely on—now and over the long term.
To learn more, please visit troweprice.com.

This material has been prepared by T. Rowe Price Group, Inc., for general and educational purposes only. This material does not provide fiduciary
recommendations concerning investments or investment management. T. Rowe Price Group, Inc., its affiliates, and its associates do not provide legal or tax advice.
Any tax-related discussion contained in this material, including any attachments/links, is not intended or written to be used, and cannot be used, for the purpose
of (i) avoiding any tax penalties or (ii) promoting, marketing, or recommending to any other party any transaction or matter addressed herein. Please consult your
independent legal counsel and/or professional tax advisor regarding any legal or tax issues raised in this material.
An IRA should be considered a long-term investment. IRAs generally have expenses and account fees, which may impact the value of the account. Nonqualified
withdrawals may be subject to taxes and penalties. Maximum contributions are subject to eligibility requirements. For more detailed information about taxes,
consult IRS Publication 590 or a tax advisor regarding personal circumstances.

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