While everyone's risk tolerance, retirement horizon, and lifestyles are different, most everyone is interested in saving money on taxes. If you are holding investments in a traditional IRA and you think you may be in a low tax bracket this year than you might be in the future, then a "focused conversion" may be a strategy to consider.
"The benefits of converting while you're in a lower bracket compound year after year. It's like getting a tax break that grows over time," explains Mitch Pomerance, CFP®, CFA, a Fidelity advisor based in Danvers, Massachusetts. Note that you won't be able to withdraw the converted balance and realize the tax benefit penalty-free until you reach age 59½ or until 5 years after the conversion, if below age 59½. Additional exemptions may apply. Taxes on earnings may still apply if you're not taking a qualified distribution.1
When rebalancing your investment mix or considering future legacy intent, this approach may allow you to pay less in taxes on the converted amount than you otherwise would. It can be a good idea to convert with assets with relatively higher potential for appreciation, such as stocks compared to bonds. Over time, those savings, coupled with the power of compounded, tax-free growth in a Roth account may mean more retirement security, higher retirement income, and a larger legacy for you and your loved ones.
There are 2 types of focused conversions
A focused conversion is a financial planning technique that is designed to improve after-tax returns for investments in traditional IRAs. In a nutshell, it involves 4 steps:
- Waiting for a year in which the investor is in a lower tax bracket than usual
- Identifying an investment to convert
- Either selling the investment and converting the proceeds to a Roth IRA or transferring the investment in-kind (paying for the cost of the conversion using assets in a taxable account in either case)
- If selling the investment, repurchasing it in the Roth IRA
Focused conversion #1: Taking withdrawals during your own lifetime. A focused conversion in a low-tax-bracket year can help reduce the overall taxes you pay during the course of your retirement plan.
Focused conversion #2: Leaving an inheritance to a loved one. A focused conversion in a low tax bracket year can lower or eliminate the tax bill a loved one pays on assets you leave behind.
A hypothetical example
Meet Joyce. She's 68, retired, and files her federal taxes jointly with her spouse. She plans to take Social Security at age 70. She has a traditional IRA as well as several other accounts that total about $1,000,000. She would like to leave a legacy for her son Andrew (age 40) who has a longer time horizon than she does.
Last year, Joyce took $30,000 from her IRA, received $50,000 from a workplace pension (for herself and her spouse), and had income from an annuity of about $40,000, resulting in total household income of around $120,000. After taking the standard deduction of $25,100 in 2021 (plus $2,700 because of her and her spouse's age), she has an estimated taxable income of $92,200.
This puts her in the 22% federal income tax bracket, which in 2021 applies to taxable income (that is, income after all deductions, exemptions, and exclusions) of $81,051 to $172,750 for joint filers. This year, she will not need income from her IRA because she and her husband downsized their home and lifestyle.
If she forgoes income of $30,000 from her IRA, she will reduce her income to $90,000. As a result, after the standard deduction of $25,900 in 2022 (plus $2,800 because of her and her spouse's age), her estimated taxable income of $61,300 this year should put her in the 12% bracket (taxable income of $20,550 to $83,550 in 2022). After this year, she expects her tax bracket to return to 22%.
Looking for opportunities to rebalance
Joyce holds a variety of funds in her traditional IRA, and she rebalances it regularly in order to stay as close as possible to her targeted asset allocation. Because of a recent increase in market volatility, Joyce's portfolio is out of balance: Her fixed income allocation is now slightly high and her equity allocation is too low, based on the objectives of her financial plan.
“This is an example where a conversion might make sense. It could create future tax-free income for herself or a legacy in the form of a Roth IRA that her son will one day take from the account tax-free,” Pomerance says.
With a rebalancing strategy in mind, Joyce plans to place a number of trades, including a sale of $10,000 of a hypothetical Bond Fund ABC and a purchase of $10,000 of a hypothetical Equity Fund XYZ.
Joyce also has $1,200 currently in cash in a brokerage account, which unlike her IRA does not have a specific targeted asset allocation and is not rebalanced regularly. She thinks of the brokerage account as her "play money" and sometimes uses it to speculate in individual stocks. But since Joyce is anticipating a broadly rising market for equities, rather than buying individual stocks, she is inclined to invest her brokerage account money in XYZ as well. She is considering 2 options:
- A conventional rebalancing trade. She would sell $10,000 of Bond Fund ABC and buy $10,000 of Equity Fund XYZ in her traditional IRA. Let's assume, for purposes of the illustration, that she would then use her brokerage account to buy $1,200 more of XYZ.
- A focused conversion. She would sell $10,000 of ABC in her traditional IRA but then convert this amount to a Roth IRA, and purchase $10,000 in XYZ shares in her Roth IRA. (Note that Joyce considers the Roth IRA and the traditional IRA as a single portfolio for asset allocation purposes.) Taxes on this trade will cost her $1,200 this year.
At first blush, if the equity market does rally, one might think Option 1 would be better than Option 2. After all, Option 1 would allow Joyce to buy a total of $11,200 of XYZ rather than just $10,000. But let's consider what would happen if, in a highly simplified and purely hypothetical example, the market does very well, and 10 years from now a $10,000 investment in XYZ has tripled and so is worth $30,000 (implying a hypothetical compound annual return of 11.61%). Given the same growth, the brokerage account investment would have reached $3,600. And let's assume around that time, Joyce would withdraw and spend the assets.
Option 1: Conventional rebalancing trade
| Account | Value today | Tax paid today | Value in year 10 | Tax burden, year 10 | After-tax value, year 10 |
|---|---|---|---|---|---|
| Traditional IRA | $10,000 | $0 | $30,000 | $6,600* | $23,400 |
| Brokerage account | $1,200 | $0 | $3,600 | $360** | $3,240 |
| Total | $11,200 | $0 | $33,600 | $6,960 | $26,640 |
Option 2: Focused conversion
| Account | Value today | Tax paid today | Value in year 10 | Tax burden, year 10 | After-tax value, year 10 |
|---|---|---|---|---|---|
| Roth IRA | $10,000 | $1,200 | $30,000 | $0 | $30,000 |
| Benefit of focused conversion (Option 2 minus Option 1) | $3,360 | ||||
*Withdrawals from the traditional IRA in year 10 are assumed to be taxed at a 22% rate.
**Liquidation of capital gains in the brokerage account in year 10 are assumed to be taxed at a 15% rate and assumption of no dividends. This rate is applied to the gain of $2,400, which corresponds to the ending balance of $3,600 minus the starting value of $1,200.
Even though it starts with a smaller investment in XYZ, Option 2 would leave Joyce with $3,360 more than Option 1. Why? Because while Option 1 does allow Joyce to purchase more of XYZ, it also leaves her with a tax bill that's so much higher, it results in her giving back all the additional gains—and then some.
20 years out: Giving a larger inheritance
Let’s look at the situation from a different point of view. Joyce would like to leave an inheritance to Andrew. She is planning to give him $10,000 from her traditional IRA and any subsequent growth alongside the $1,200 from her brokerage account to help cover taxes he might owe. She plans to invest both similarly. Alternatively, she is considering a Roth conversion.
In considering the Roth conversion, she intends to transfer $10,000 of her investments in-kind instead of selling the investments outright and buying them in a Roth. Despite nothing being sold, she still performed a Roth conversion and now will owe $1,200 (or 12%) of federal tax liability.
Let’s suppose after 20 years, Joyce passes away and leaves the Roth account to Andrew. At this point, the stock would be worth $67,275 assuming a hypothetical annual tax-free compound rate of return of 10%.
Let’s look at the Roth conversion approach side-by-side with her original plan to leave the traditional IRA and brokerage account.
Option 1: Conventional rebalancing trade
| Account | Value today | Tax paid today | Value in year 20 | Tax burden, year 20 | After-tax value, year 20 |
|---|---|---|---|---|---|
| Traditional IRA | $10,000 | $0 | $67,275 | $14,800* | $52,475 |
| Brokerage account | $1,200 | $0 | $8,073 | $1,031** | $7,042 |
Option 2: Focused conversion
| Account | Value today | Tax paid today (in Joyce’s tax bracket) | Value in year 20 (Andrew inherits the Roth account) | Tax burden, year 20 (in Andrew’s tax bracket) | After-tax value, year 20 |
|---|---|---|---|---|---|
| Roth IRA | $10,000 | $1,200 | $67,275 | $0 | $67,275 |
| Benefit of focused conversion (Option 2 minus Option 1) | $7,758 | ||||
*Withdrawals from the traditional IRA in year 20 are assumed to be taxed at a 22% rate.
**Liquidation of capital gains in the brokerage account in year 20 are assumed to be taxed at a 15% rate and assumption of no dividends. This rate is applied to the gain of $6,873, which corresponds to the ending balance of $8,073 minus the starting value of $1,200.
Nevertheless, when it comes to financial planning, there are details that can make things a bit more complicated. In our first scenario, since the value of her investment in XYZ triples, Joyce may need to rebalance again, so she might not be able to keep all of her investment in XYZ.
"Remember, a focused conversion isn't foolproof," says Pomerance. "It's possible that a future reduction in tax rates or some other change in tax law could mean that the benefits of focused conversion could be reduced or even eliminated. The overall goal for most people doing a focused conversion would be that their future taxable income could be lowered."
Bumping up against net investment income thresholds
In addition, there are several other factors that could make a focused conversion even more attractive. For example, qualified distributions from a Roth IRA are not counted for purposes of figuring the taxation of Social Security benefits, which might be an important additional benefit for those with lower incomes than Joyce. For those with higher incomes, this strategy may help keep income levels below certain thresholds, which could reduce Medicare premiums (sometimes referred to as the income-related monthly adjustment amount, or IRMAA) and/or the 3.8% Medicare surcharge (see chart). Finally, Roth IRAs aren't subject to required minimum distributions during the original owner's lifetime,2 so Roth conversion may also help investors avoid taking IRA withdrawals (and generating tax liability) that they don't need.
3.8% Medicare surcharge threshold amounts
| Tax filing status | Threshold MAGI* level |
|---|---|
| Married filing jointly | $250,000 |
| Married filing separately | $125,000 |
| Single | $200,000 |
| Head of household (with qualifying person) | $200,000 |
| Qualifying widow(er) with dependent child | $250,000 |
Since the details can make a difference in determining taxes paid over a number of years, it's a good idea to consult with a tax advisor or a financial professional before implementing a focused conversion. That can help make sure that you've considered all the possibilities and that the strategy fits into your broader financial plan.