Talk of The Villages Florida - Smart vs Dumb Roth Conversions

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Sportsguy's Note: the author only looks at marginal income tax rates, not the entire financial picture. . such as IRMMA and other retirement scenarios. .

Dumb and Dumber
The essence of dumb is to pay a lot of money for the privilege of moving money under the Roth shelter. Which brings us to Roth conversions.

The first thing to understand: Whenever the Federal government changes the law to replace regular retirement options with Roth options, the Joint Committee on Taxation, which scores tax provisions for their revenue impact, records the switch to Roth as a positive for government revenue.

Think about that: The government records new Roth provisions as a revenue gain. You think you are paying tax on the conversion now, to save more tax later. The government thinks it gains when you think that way.

On what grounds could the government possibly score tax-free-forever accounts as a gain?

It’s obvious: If you convert $100,000 from your traditional 401(k) while in the 24% bracket, you pay $24,000 to the government today, all of it at once, in a lump sum. You betcha the government likes that!

Of course, in your mind the upfront tax payment is an investment. You are staring at substantial RMDs coming soon. If you don’t do that $100,000 Roth conversion, your first RMD is going to be …. wait for it … $3,774 higher than otherwise. At 24%, you’d have to pay $906 on that un-averted RMD. Or, if the Big Beautiful Bill had failed and the 2017 Trump tax cuts expired at the end of 2025, the tax would be 28%, or $1,057.

Who wouldn’t jump at the chance to pay $24,000 now to avoid spreading out the payments at $1,000 a year for the next two decades?

Oops. That came out wrong. Try this: “What taxing authority would not jump at the chance to receive $24,000 in hand, as opposed to waiting for that same amount to dribble in over decades?”

And since the Big Beautiful Bill did pass, extending the 24% rate, our erstwhile converter will have made a $24,000 interest-free loan to the government, paid back over decades in a slow dripof RMD taxes averted. With no gain at all in net present value terms. Don’t forget the commutative property of multiplication from junior high algebra: If the tax rate doesn’t change, it doesn’t matter whether you take the tax haircut at the conversion or upon distribution. There’s no gain under a constant rate.

And what if a future Congress lowers taxes further, as occurred in 2003 and 2017, bringing the new tax rate in this bracket down to 21% beginning, say, 2029?

Dumber! Now the conversion will lose money, bleeding year after year, as you paid 24% upfront to save on tax at 21% due in dribs and drabs over decades.

Whoa — Not So Fast!
Hey bud — that $100,000 moved into the Roth doesn’t just sit there, it earns 10% in the stock market. And the second year RMD percent is 3.92%, making that second RMD on the appreciated account $4,312. At 28%, that is $1,207 in tax averted by reducing your RMDs through conversion. And the dollar amount of tax saved will climb rapidly from there as your stock portfolio goes up and up!

Excellent point: We should be dealing in the future value of funds, not fixating on the initial $100,000 amount converted here in 2025. But sauce for the goose is sauce for the gander. That $24,000 paid over to the government today has a future value too. It could have been left in the traditional account, invested in stock, and also appreciated 10%, to $26,400, then $29,040, etc.

Future value has to be netted against future value. We say again, the payoff from a conversion designed to reduce RMDs will take decades.

Make no mistake: If the tax rate on your future RMDs does increase to 28% and stays there for decades, and you converted $100,000 today at 24%, the expected net present value of the conversion is positive, at $4,000. But you book that gain RMD by RMD, year by year, and only if the tax rate doesn’t change.

If taxes do ever drop, due to legislation or a change in taxpayer circumstances, back to the level at the time of conversion, then the payoff from the conversion stops. You gain only the value of the averted tax booked to that point. The rest of the conversion tax resumes its status as an interest-free loan to the government.

Two final points: If you’re the charitable type, you can donate up to $108,000 per year from a traditional IRA after age 70½, on which not a penny of tax has ever been paid. Or if, God forbid, you need medically necessary long-term care, much of that can also be deducted from your reported RMD income. In which case paying for a Roth conversion will have been really dumb.

Conclusion
We’ve come a long way from Peter Thiel. From saving a billion dollars in taxes, to saving $151 per year, over decades, by converting $100,000 at 24% now to avert taxation of RMDs at 28%. In the best case.

That’s 15 basis points on the $100,000.

Now remember, we have nothing against Roth accounts.

To prove it, let’s change the circumstances again. Suppose you are Rosy Kalkulus’ parents and she the only heir. Converting today at 24 percent means that decades later, she might not have to pay 44 percent on large sums withdrawn over 10 years under SECURE 2.0. Not so dumb.

Smart Roth means not paying too much, preferably zero, to shelter surplus funds you don’t plan to spend in your lifetime.

Put it on a T-shirt: Roth for our heirs — not us.

Edward F. McQuarrie, Ph.D., is Professor Emeritus at Santa Clara University. He writes about financial history and its implications for retirement planning. Working papers describing his research can be downloaded at Just a moment....