The Arithmetic of Roth Conversions

In our recent posts from March, April, and May 2023, we highlighted some important considerations when making a Roth conversion. In this post, we continue this conversation with a recent article published in the May 2023 edition of the Journal of Financial Planning, entitled “The Arithmetic of Roth Conversions”. I was very fortunate to co-author this article with my colleague Dr. Edward McQuarrie, Emeritus Professor at Santa Clara University.

McQuarrie, Edward F., and James A. DiLellio. 2023. “The Arithmetic of Roth Conversions.” Journal of Financial Planning 36 (05): 72–89.

Executive Summary

• Roth conversions continue to vex planners. To clarify matters, this paper submits conventional rules of thumb to a strictly arithmetic analysis.

• The treatment shows that it must be optimal to pay tax outside the conversion with cash, confirming one common rule. But if tax must be paid to raise the cash used to pay the conversion tax, there will be an initial loss on the conversion and a subsequent breakeven point. This paper shows how to determine time to break even.

• By the same arithmetic, the paper refutes the common rule that future tax rates must be higher for a conversion to pay off. Given enough time, conversions can overcome moderately lower future tax rates and still produce a substantial payoff due to the power of compounding.

• Most Roth conversions will show a substantial payoff if the client’s planning horizon stretches over decades; however, shorter time frames may produce only a minimal payoff or even a loss.

• The paper gives practical advice regarding the optimum time to convert, points in the tax structure that favor or disfavor conversion, and the clients most and least likely to receive a substantial payoff from conversion.

Key points to consider when reviewing “The Arithmetic of Roth Conversions”

This article highlights the importance of the following key items:

  1. Current and future tax rates
  2. How time can help a conversion generate a positive payoff
  3. The type of retirees well suited and not suited for Roth conversions

We also encourage you to try our retirement income calculator. It was recently updated to include both optimal account drawdowns and Roth conversion analysis.

We hope you find this latest research article helpful in your own retirement planning or your financial planning practice!

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ETFMathGuy is a subscription-based education service for investors interested in tax-efficient investing with ETFs

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