When and for Whom are Roth Conversions Most Beneficial? A New Set of Guidelines, Cautions and Caveats

Abstract

Much has changed since penalty-free Roth conversions were inaugurated in 2010. Tax rates have gone up and down. The re-characterization provision went away. Heirs can no longer stretch out inherited Roth accounts over a lifetime. Medicare surcharges were expanded and began to adjust for inflation. The age to begin Required Minimum Distributions was pushed out to age 72 and the IRS changed the RMD divisor tables to further slow the pace of distribution. Given these developments it seemed worthwhile to re-examine the rationale for Roth conversions. That effort exposed multiple flaws in conventional wisdom: • Future tax rates need not be higher for a conversion to pay off; • Nor is it all that helpful to pay the tax on conversion from outside funds; • Nor are Roth conversions especially beneficial for top bracket taxpayers as compared to middle class taxpayers; • Rather, the greatest benefit accrues to taxpayers who can make the conversion partly in the zero percent tax bracket, i.e., during a year with no other taxable income. While the benefits from a Roth conversion are often small and slow to arrive, a Roth conversion will almost always pay off if given enough time, i.e., for life spans that extend past 90 and so long as annual distributions from converted amounts are not taken. Roth conversions work because of compounding, which requires the conversion to be left undisturbed for a long time. The paper elucidates the role played by the mathematics of compounding in underwriting the success of Roth conversions.