Ever since Roth conversions were liberalized in 2006, a steady stream of accounts have appeared in various media outlets, purporting to show that you ought to do a Roth conversion. Most accounts wave the bloody shirt of Required Minimum Distributions (RMD), and the dread tax burden you will someday suffer, if you don’t convert to a Roth right away.
I’ve never been convinced that Roth conversions are a good idea for ordinary people (a few very wealthy people may benefit). Here is a deconstruction to help armor you against such seductions.
The March 2015 AAII Journal article, “Converting to a Roth IRA Can Minimize RMDs,” purports to show that Roth conversions may be advantageous for a 54 year old taxpayer in the 28% bracket. Let me expose hidden assumptions that call the analysis into question.
The general rule: Roth conversions only make sense if the tax rate in retirement will be higher than the tax rate at time of conversion. This outcome rarely occurs for an ordinary middle income person who is in the 28% bracket while working (see below). The article goes further and tries to show a Roth advantage for a taxpayer who stays in the 28% bracket throughout, rather than suffering an increased tax rate in retirement. Just a few calculations will show the absurdity.
In 2015, a married couple had to earn more than $171,800 [$151, 200 (=28% bracket threshold) + $12,600 (=standard deduction) + $8000 (=two personal exemptions)], before a Roth conversion, or an RMD, could be taxed at 28%.
Since Reagan, brackets have been adjusted each year for inflation; let’s project 3% inflation. Therefore, at age 71, our hypothetical tax payer, for RMDs to be taxed at 28%, must earn over $275, 690—the expected 28% threshold in 2032, after inflation adjustments. The article, top left of p. 32, makes it clear that RMDs are assumed to be taxed at 28%.
Where did that $275,000 income come from? Not from tax deferred accounts—these are being converted to Roth. Not from taxable investments—these are paying tax on the conversion. Still working, at that wage level, at age 71? Then truly, RMD would be inconvenient!
But wait—in the example, the tax on RMDs stays at 28% through age 94. With inflation, the 28% rate, in 2055, will begin above an income of $560, 421. What 94 year old has that income, not from retirement accounts, and not from taxable accounts? Mr. John D. Rockefeller the VII? Mr. Cornelius Vanderbilt the IX? Not readers of the AAII Journal.
Here’s what will actually happen, for a 54 year old couple with $500,000 in tax deferred accounts, annual contributions of $6500, and a return of 6%. They will have just under $1.6 million when their RMDs begin at 71—assuming no trust fund, inheritance, or other deus ex machina. This relatively small amount reflects their lack of thrift: they now put away less than 3.5% of income per year, and the small current account value of $500,000 shows that’s all they’ve ever saved. Tax on RMDs will be the least of their worries—they aren’t saving enough to fund a comfortable retirement.
Their first RMD will be about $58,000; after deducting the inflation-adjusted standard deduction and personal exemptions, the remainder falls within the inflation-adjusted 10% tax bracket.
Pretty silly, to make a Roth conversion now, taxed at 28%, to reduce a future RMD, which would be taxed at 10%.
The Knock on Roth Conversions
This simple example reveals most of the sleight of hand behind pitches for Roth conversions. Here are a few simple rules to help you lift the curtain on the magic show.
- Conversions are taxed at your marginal rate. RMDs are taxed at your blended or average tax rate.
- In a progressive tax structure, unless the entire structure shifts way, way up, then for a stated income level, the average tax rate, in retirement, must be lower than the marginal tax rate, while working.
- Therefore, unless you are such a bodacious investor that you will earn much more from your investments, while retired, than you earned from your wages, while working, a Roth conversion makes no sense. You’d pay high taxes now to save on low taxes later. Dumb.
Typical Objections
#1: But tax rates could change!
Yep, they certainly could. Bernie Sanders might get elected, and raise the whole tax structure. But instead Donald Trump might get elected, and lower the entire tax structure. Or Steve Forbes might return, and put in a flat tax. Wouldn’t you feel silly, converting to a Roth at Democratic tax rates, when you could have waited to take your RMD, under Republican tax rates?
#2: But at least a Roth conversion would hedge my tax change risk, or put another way, diversify my potential tax liabilities
Nope. It’s one US Congress making all the tax rules. Congress can raise the rates on regular income, making you rue the day you passed on a Roth conversion; but Congress can also alter the terms governing Roth distributions, making you rue the day you made that conversion. There is no diversifying your Congressional risk.
People forget that hedging does not guarantee a profit; it simply limits particular risks, for a known cost. Consider the airline CEO, who in 2014 locked in his 2016 oil costs at $100 / barrel. That airline no longer has to worry about 2016 oil prices shooting up to $150, $200, or higher. Lucky them.
So also the Roth convertee, who doesn’t have to worry about Bernie Sanders getting elected, but also, can’t benefit if a Republican is elected. He’s hedged!
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