Optimal decisions under price dynamics for Roth conversions

As the April 15th tax deadline approaches, many retirees may be considering the trade-offs associated with Roth conversions. Seeking optimal decisions can be challenging! In this post, we highlight a peer-reviewed journal article recently published in the Financial Planning Review and add to our previous discussion on this topic.

Timing your tax payments

Ordinary income taxes may occur during retirement from tax-deferred account distributions, like withdrawals from a 401(k) plan. However, by conducting a Roth conversion, a retiree can move these tax-deferred assets to a Roth account where future withdrawals are generally tax-free. But, to do so, they may owe taxes on the distribution. There are other rules too. For example, retirees may not convert required minimum distributions. Nevertheless, many financial planners consider Roth conversions when a client’s taxable income is unusually low, thereby taking advantage of lower tax rates in our progressive tax system.

Key Insights

This article provided many important insights when seeking optimal decisions on Roth conversions.

• If funding the Roth conversion from retirement assets, the conversion will be solely dependent on future tax rates. Thus, the conversion will have a positive (negative) payoff if future tax rates are higher (lower) than the rate paid to convert.
• If funding the Roth conversion from non-retirement taxable assets, the cost basis of these assets plays an important role. So, the lower the cost basis of these assets used to fund the tax liability caused by the conversion, the less likely that a positive payoff will occur.
• Using non-retirement assets to fund the Roth conversion’s tax liability also creates a payoff dependent on market returns. Stronger market returns lead to a greater payoff. Also, the calculus of this optimal decision changes significantly whether the non-retirement assets will ever need to be used by the retiree, or if they will receive a step-up in cost basis when left to an heir.

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The bottom line on optimal decisions for Roth conversions

Making an optimal decision on converting tax-deferred retirement funds to a Roth IRA is not simple. As the results of this research show, there may be situations where it is worthy of consideration. But, there are also many scenarios when Roth conversions should not be pursued. Not sure how it may affect your situation? Our optimal retirement income calculator now includes a Roth conversion analysis. And, you can try it for free!