Editor’s note: Across the gamut of our 2023 articles explaining tax law changes, the bewildering economy, and how to be a better advisor, these Members’ Choice runner-up articles equipped you for powerful performance. These just missed a spot in our annual Top 10 list, but were still among the most popular articles of the year.
By now, we are all well versed in the benefits of Roth conversions in a rising tax rate environment: decreased RMDs and therefore decreased taxes…more flexibility and control on where to withdraw money in retirement…more after-tax wealth to leave to heirs…and so on. And no matter how you look at it, discussing and implementing Roth conversions should be in full swing.
At Taylor Financial Group (TFG), we believe in the value of Roth conversions in many situations. This article focuses on how to approach Roth conversions when a position, or markets, are down, essentially increasing the tax savings and value of the conversion.
At TFG, we have been having daily conversations with clients for some time now regarding the importance of Roth conversions. We are discussing their projected income for the year, projected taxes, and the expected benefits to the client, the surviving spouse or partner and heirs.
The 3-part test to analyze all Roth conversions
Indeed, we have created a three-part framework to break down our approach to Roth conversions. We develop our Roth recommendations at TFG by looking at three critical criteria, any one of which will tilt us in favor of a Roth recommendation.
We compare the client’s current tax rate to projected tax rates in three different scenarios. We recommend a Roth conversion if the client’s current tax rate is lower than the projected tax rate in any of the following scenarios:
- The projected tax rate in retirement is 24%–28%
- The projected tax rate after the first spouse passes and must file single (widow’s penalty) is likely 32% bracket
- The projected tax rate after the second partner passes and taxes are to be paid at the beneficiary’s tax rate is potentially the 32% bracket or higher
Despite our thoughtful and very analytical approach, some clients are more receptive than others to our recommendations.
And now the objections…
For some clients, it is easy to see how they could be in a higher tax bracket in retirement, making the Roth conversion (and resulting tax payment) an easier pill to swallow. They do not fight us. We will provide projections of cash flow and taxes for the three scenarios we lay out above to make the case. And many clients agree to move forward based on this work alone.
Other clients need more prodding…
“What if taxes don’t go up?” Doubtful.
“What if our taxes don’t go up?” Also doubtful, but we dig into the details.
“What if the government changes the laws and does away with Roth conversions?” Again, doubtful. In fact, the government is going in the exact opposite direction by mandating Roth contributions in SECURE Act 2.0 for the expanded catch-up contributions made by employers.
Explaining how Roth’s are ‘on sale’
Once we address these objections (and some others), we emphasize to clients that Roth’s are “on sale” these days. The market is down since January 2022 and flat on the one-year, so this is a great opportunity to pay less in taxes than you otherwise would, assuming that the market rebounds (which we do).
In addition, even if the client’s overall account is positive, many clients still have losing positions in the portfolio that could be used for the Roth conversion. It is here that quantifying the tax savings of doing a Roth conversion now while the market is down (or flattish) can motivate the client who is prone to cynicism or procrastination.
So, what are the actual numbers? Let’s review a real-life client situation below, using Holistiplan to lay out the case.
Per the situation below, converting $45,000 of depressed assets today at the 24% bracket would create a federal tax bill of about $10,814. Should the market rebound and that account grows closer to $55,000, the client essentially only paid a ~20% tax rate on the conversion of those monies ($10,814/ $55,000 = 19.66%). Therefore, this presents the client with a unique opportunity to essentially save 20% on their tax bill.
2022 Base case: No Roth conversion
(24% marginal bracket)
- Total income: $270,824
- Taxable income: $243,492
- Estimated federal tax: $47,603
- Estimated state tax: $16,102
- Estimated total tax: $63,705
Scenario 1: Roth conversion of $45,000
(Stay in 24% marginal bracket)
- Total income: $315,824
- Taxable income: $288,492
- Estimated federal tax: $58,417
- Estimated state tax: $18,951
- Estimated total tax: $77,368
- Additional Estimated Federal and State Tax from Base Case: $13,663
- Incremental Cost of Conversion: $10,814
Scenario 2: Roth conversion of $55,000
(Stay in 24% marginal bracket)
- Total income: $325,824
- Taxable income: $298,492
- Estimated federal tax: $60,817
- Estimated state tax: $19,336
- Estimated total tax: $80,153
- Incremental cost of conversion: $13,214
- Additional estimated total tax from base case: $16,448
- Additional estimated total tax from Scenario 1: $2,785 (represents the tax savings of converting at a depressed value as in Scenario 1)
Per the above, you can see a tax savings of almost $3,000 by converting while a position or account is depressed, as there is an additional tax of almost $3,000 if you were to convert $55,000 (Scenario 2) instead of $45,000 (Scenario 1) while in the 24% marginal tax bracket.
Converting a depressed position for someone in highest tax bracket
In addition, see below where converting a depressed position to a Roth could also make sense for someone in the highest tax bracket, as it would essentially decrease the tax bracket at which they are converting (taking the sting out of converting at such a high tax bracket). For example, if an account was valued at $120,000 in early January 2022, it would likely have a value of about $100,000 as of today. If you convert those monies today (assuming a 37% tax rate), you would pay about $35,069 in taxes on the conversion.
If you waited to convert the same account in 2024, assuming the value went back up to $120,000, a conversion at that time at the lower 32% tax rate (assuming the client retires and has lower income) would create a tax bill of about $36,136. Therefore, you could save a bit in taxes with a conversion of the same monies today even at a higher tax rate because the account value is depressed (see detailed analysis below).
Scenario #1: Roth Conversion of $100,000
*37% Marginal Bracket*
- Total income: $680,000
- Taxable income: $651,300
- Estimated federal tax: $178,500
- Estimated state tax: $43,595
- Estimated total tax: $222,095
- Incremental cost of conversion: $35,069
Scenario #2: Roth Conversion of $120,000
*32% Marginal Bracket*
- Total income: $460,500
- Taxable income: $431,800
- Estimated federal tax: $99,454
- Estimated state tax: $25,037
- Estimated total tax: $124,491
- Incremental cost of conversion: $36,136
Per the above analysis, converting an account (or a position) with a depressed value could create a slightly lower tax bill than in the future when the client is in the lower 32% bracket (2024), but converting the same account or shares at a higher value.
To be clear, a tax savings on the current tax rate only makes sense if the case for the Roth still satisfies one of the three criteria we set forth above: (1) tax rates are higher in the future once RMDs and Social Security kicks in, (2) tax rates are higher once widow’s penalty kicks in, or (3) tax rates are higher for the beneficiaries once the second partner passes. Only then does this approach make sense, in that a drop in value allows you to essentially convert today’s depressed funds at a discount. Again, this entire analysis assumes that the market rebounds, which we believe it will. Having said all of that, we are finding that creating this framework is greatly assisting clients in understanding the many short- and long-term benefits of a Roth conversion.