Roth conversions can save retirees six or even seven tax figures over their retirement years. But when do these benefits actually materialize? Many people misunderstand when the break-even point occurs, leading to poor decision-making about this powerful tax strategy.
James Conole analyzed a retirement plan for Luke (61) and Mary (58), who have $2.32 million in investments. Their portfolio includes substantial pretax accounts (IRA and 401(k)), a small Roth IRA, and nearly $1 million in their brokerage account. They plan to retire at 63 and 60, respectively.
The Power of Roth Conversion Strategy
For Luke and Mary, filling up the 22% federal tax bracket until Luke reaches 72 would be most beneficial. This strategy is projected to:
* Provide $3.3 million more in tax-adjusted ending assets
* Save $3 million in taxes throughout retirement
* Reduce required withdrawals from traditional IRAs by almost $6 million
These numbers are impressive, but the critical question is: when will they actually see these benefits?
The Misleading Dollar-Value Break-Even Point
When looking at Luke and Mary’s retirement projection, something surprising appears. If we compare their baseline plan (without Roth conversions) to the proposed plan (with Roth conversions), the dollar-value break-even point doesn’t occur until Luke is 95 and Mary is 92!
This seems discouraging. Why implement a strategy if the benefits won’t materialize until the end of life?
The answer lies in understanding what we’re actually measuring. When you convert money from a traditional IRA to a Roth IRA, you pay taxes now that you otherwise wouldn’t have paid. For example, converting $100,000 at a 22% tax rate means paying $22,000 in taxes now. That’s $22,000 less in your portfolio, plus the opportunity cost of what that money could have earned had it remained invested.
This creates the illusion that the break-even point is far in the future. But this is the wrong way to look at it.
Tax-Adjusted Asset Value: The True Measure
Consider this question: Would you rather have $1,000,000 in a traditional IRA or $1,000,000 in a Roth IRA? The answer is obvious—the Roth IRA is more valuable because it’s completely tax-free.
But what about $1,000,000 in a traditional IRA versus $900,000 in a Roth IRA? Or $800,000 in a Roth IRA?
The key insight is that we shouldn’t compare dollar amounts but tax-adjusted asset values. If you’re in the 25% tax bracket, $1,000,000 in a traditional IRA is only worth $750,000 after taxes, while $800,000 in a Roth IRA is worth the full $800,000.
When Benefits Actually Materialize
Let’s use a more straightforward example to illustrate when the real break-even occurs:
You have $10,000 in an IRA and are in the 12% tax bracket. You convert it to a Roth IRA, paying $1,200 in taxes. You now have $8,800 in your Roth IRA (assuming taxes are paid from the converted amount).
At this point, both scenarios have the same tax-adjusted value:
– $10,000 in traditional IRA × (1 – 0.12) = $8,800
– $8,800 in Roth IRA = $8,800 (no taxes)
Now, imagine that next year, your tax bracket will increase to 22%. Without any growth:
– $10,000 in traditional IRA × (1 – 0.22) = $7,800
– $8,800 in Roth IRA = $8,800 (no taxes)
Suddenly, the Roth conversion has created $1,000 in tax-adjusted value! The break-even occurred as soon as your tax bracket increased.
The Real Value of Roth Conversions
The true break-even point for Roth conversions isn’t when the dollar amounts equalize decades later. It’s when your tax-adjusted portfolio balance increases due to the conversion strategy. This typically happens when your asset makeup keeps you in a lower tax bracket than you would have been without conversions.
For most retirees, this happens much sooner than the misleading dollar-value break-even point suggests. Understanding this distinction can help you make better decisions about implementing Roth conversion strategies in your retirement planning.
When viewed correctly, Roth conversions can provide benefits much earlier in retirement, allowing you to enjoy more of what you’ve worked hard for.
Frequently Asked Questions
Q: How do Roth conversions actually save money on taxes?
Roth conversions save money by allowing you to pay taxes now at a potentially lower rate than you would pay later. When you convert traditional IRA funds to a Roth IRA, you pay income taxes on the converted amount at your current tax rate. Later, when you withdraw from the Roth IRA, those withdrawals are entirely tax-free, regardless of how much the account has grown or what tax bracket you’re in at that time.
Q: Should I pay the taxes for a Roth conversion from the converted amount or from other sources?
It’s generally more advantageous to pay conversion taxes from non-retirement accounts (like cash savings or brokerage accounts) than from the converted amount itself. This allows you to move the full amount to the Roth IRA, where it can grow tax-free. When you pay taxes from the converted amount, you reduce the power of tax-free growth on those dollars.
Q: At what age should I consider doing Roth conversions?
Roth conversions can be beneficial at various ages, but they’re often most strategic between retirement and age 72 (when Required Minimum Distributions begin). During this period, many retirees have lower incomes and may be in lower tax brackets, making it an opportune time to convert. However, each situation is unique, and factors like your current and projected future tax brackets, overall financial crisis, and legacy goals should be considered.
Q: How much should I convert to a Roth IRA each year?
The optimal amount to convert depends on your tax situation. A common strategy is to “fill up” your current tax bracket—converting just enough to reach the top of your current bracket without pushing into the next higher one. For example, if you’re in the 22% bracket, you might convert enough to reach the threshold of the 24% bracket. This approach maximizes the amount converted while minimizing the tax rate paid.
Q: Will Roth conversions affect my Medicare premiums?
Yes, Roth conversions can potentially increase your Medicare premiums temporarily. Medicare Part B and Part D premiums are based on your modified adjusted gross income (MAGI) from two years prior. A large Roth conversion will increase your MAGI for that year, which could push you into a higher premium bracket. This is an important consideration when planning conversion amounts and timing, especially for those already on Medicare.
