Roth IRA Conversions: How Much Is Too Much?

Welcome to Hidden Value, the column where Joe Elsasser, CFP, addresses common financial planning issues with insights advisors and their clients may not have considered.

Q. How much should my client convert to a Roth?

A. The tax overhaul passed in 2017 significantly lowered marginal income tax rates for most people, and many advisors are now evaluating Roth conversions for their clients. However, while it seems like the deliberation is whether or not to convert the entirety of an IRA balance to a Roth, I would suggest the right question is "how much should I convert to Roth?" And don't forget the related question: "How much is too much?"

Considerations for Roth conversions are often made from a single-year viewpoint. It is most common to consider Roth conversions when a client is at the edge of a tax bracket. For example, a client in the middle of the 12% tax bracket may want to consider converting enough IRA to Roth IRA to fill the 12% bracket, but avoid any withdrawals being taxed at 22%. Because the jump from 12% to 22% is so significant, it's unlikely a client would want to convert his or her entire IRA.

For other clients who are likely to be in the 22% or 24% bracket for the rest of their lives, converting to the top of the 24% bracket may make sense, since the next bracket is a full 8% higher rate, at 32%. The tax brackets of the client's children will often be a key consideration for this group.

An additional wrinkle when considering conversions for higher income people is Medicare. If they are within two years of Medicare or already over 65 years old, then it is worth considering conversions to the point the client would pay additional Medicare part B and D surcharges, which are not calculated as tax directly, but are based on modified adjusted gross income. Quantifying the single-year impact of various conversion strategies enables a client to make an educated decision about the costs of a conversion and avoid potential pitfalls like entering a new bracket or creating unnecessary Medicare expenses.

The conversion decision also needs to take into consideration the lifetime impact of the conversion. Take a middle-income couple, for example. The standard deduction for a couple filing jointly in 2019 is $24,400, and there is an extra deduction of $2,600 if both are over 65 years old. Doing some round-number math, ignoring inflation and account growth, you would expect that over a 30-year retirement, this couple could have about $800,000 of ordinary income without paying any tax at all. If the couple has pensions, the amount from the IRA would be reduced, but it could still be significant.

In the absence of the interactions between Social Security benefits, long-term capital gains and qualified dividends, and in the absence of pension income or ordinary income from nonqualified accounts, it would be easy to say that couples should keep at least their remaining life expectancy times the standard deduction in a traditional IRA because that money would be accessible over their lifetime without paying tax. However, in the presence of these interactions, it is worth considering, given a reasonable estimate of annual Social Security benefits and other income, how much, on average, the client can have in ordinary income without paying tax. That amount multiplied by life expectancy should be the minimum that remains in the IRA after all conversions are complete.

In short, when contemplating Roth conversions for your clients, consider not only the bracket they are in today and the starting points of adjacent tax brackets, but also the client's, or in some cases, their beneficiaries', tax bracket in the future. Consider a lifetime minimum IRA balance as the amount the couple can keep in traditional IRAs with a reasonable expectation that they won't artificially lower their future tax bracket because they paid more in tax than necessary today.

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