A Roth conversion typically moves pre-tax funds from an Individual Retirement Account (IRA) to a Roth IRA. Doing so adds income to the year when account holders convert, so may trigger additional income taxes. But, future withdrawals from the Roth IRA should be tax-free. We’ve discussed some research on this topic before in our article published in the Financial Planning Review. Ed McQuarrie, Emeritus Professor from Santa Clara University just published another article on the topic. It now appears on page 76 in the September 2024 edition of the Journal of Financial Planning. This post will highlight the key findings in this important research related to retirement income and estate planning. We also highlight how our retirement income calculator aligns with these insights for a retiree’s particular scenario.
New research contribution
Prof. McQuarrie’s research focuses on the Roth conversion’s Net Present Value (NPV). NPV is an important metric used to value projects, which states that discounted future cash flows must sum to a positive number to add value to the project’s owner. His journal article highlights when NPV turns positive based on the time since the conversion occurred,
As Figure 2 demonstrates, a positive NPV occurs when the retiree reaches age 86. More or less favorable assumptions about future tax rates can decrease or increase the time for NPV to turn positive, and this article highlights a few insightful examples.
Risks in future tax code and individual circumstances
The article continues by discussing several risks faced by a Roth conversion. For example, since the U.S. Congress sets tax laws, taxpayers will never know for certain what income tax rates may be in the future. The Tax Cut and Jobs Act (TCJA) that expires in 2025 may or may not be extended or modified in ways that are favorable to a Roth conversion today. Also, consideration of an heir’s tax rate is important for retirees who have excess funds they wish to pass on after their death. Heirs at lower tax brackets, and certainly heirs who are charitable organizations who may not owe tax on IRA bequests, may benefit more financially in receiving assets from an IRA rather than a Roth IRA. Conversely, a surviving spouse utilizing the standard deduction could significantly benefit from a conversion before the passing of their spouse.
How to assess a Roth conversion for your situation
Given all these complexities, a thoughtful analysis is important before making a Roth conversion. One approach is to use software, like our Retirement Income Calculator. And, given this latest research, there are many nuances to consider before conducting a Roth conversion. This research article nicely highlights four scenarios when a conversion is the least risky and four scenarios when they are most risky and is worthy of review for anyone considering a Roth conversion in the coming years.
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