Investors typically decide whether to convert to a Roth IRA from a traditional IRA by comparing their current and expected future marginal tax rates. The rule of thumb has been that higher future tax rates make a conversion more desirable, while lower tax rates make it less so.

While the tax rate comparison is one important aspect to Roth conversions a more sophisticated approach is worth considering when trying to lower your future taxes and increasing your net worth in retirement . Below is a discussion on other important factors including where conversion taxes should be paid from, IRA cost basis, and backdoor Roth contributions.

Future Tax Rate

When the marginal tax rate stays the same, the Roth and the traditional IRA will generate the same after-tax withdrawal values, even though Roth taxes are paid at the time of contribution (as contributions are made with after-tax dollars) and traditional IRA taxes are paid at the time of withdrawal. Because future qualified withdrawals from a Roth IRA aren’t subject to income tax, the withdrawal value of a Roth IRA remains unchanged whether the tax rate goes up or down. With a traditional IRA, on the other hand, a different future tax rate affects the amount of taxes incurred by a withdrawal, since such taxes are paid at the time funds are withdrawn. Thus, a higher future tax rate would make a Roth IRA more attractive, while a lower future tax rate would make a traditional IRA more appealing.

Given that future tax rates are uncertain for many reasons, many investors may want to diversify this tax risk through partial conversions.

Maximize lower income years

A Roth conversion can be even better in years when there are favorable tax attributes, such as low income or large deductions. Self-employed individuals with lower revenue one year or increased business deductions should consider conversions.

Another common circumstance for low income years is the time between retirement and required minimum distribution (RMD) years. The 2020 SECURE Act changed the first RMD year to age 72 for those born after June 30, 1949 giving many more people the chance to spread Roth conversions over additional years and keep income below higher marginal tax rates.

Large deductions from charitable giving is another opportunity to increase Roth conversions. For the charitably-inclined individual they may consider pre-funding future years of giving in the year of conversion through the use of a Donor-Advised Fund. The DAF funding creates a large charitable deduction which may be used against the conversion income.

Pay taxes from a taxable account

A Roth conversion can be very attractive if you can liquidate assets held in a taxable account to pay the conversion income tax. In effect, the conversion allows more dollars to be placed within a tax-advantaged account. This option becomes even more attractive if the liquidated assets are tax-inefficient or the investment horizon is long. Essentially, paying conversion taxes from a taxable account lets you move some of your savings (the amount of the conversion taxes) from a taxable account to a Roth account. This increased efficiency helps even if the future tax rate is lower than the current rate.

Paying Roth conversion taxes from a taxable account decreases the break-even tax rate the longer those dollars are held in the Roth. That’s because shifting money from a taxable to a tax-free account shields its future returns from annual taxation. In other words, the investor accepts a tax liability today to avoid future taxation on the compounded growth of those dollars.

Consider your IRA cost basis

When traditional IRAs are converted to Roth IRAs, it is only the pre-tax balance of the IRA that is subject to income taxation. If the IRA was funded entirely with pre-tax contributions, the entire account balance is fully taxable when converted. However, many investors have IRAs that were funded with after-tax contributions (meaning an income tax deduction was not made in the year of contribution). In these cases, only the investment earnings would be subject to income taxation when withdrawn.

The higher the proportion of basis in a traditional IRA the lower the break-even tax rate. IRA cost basis equals the amount of nondeductible contributions you've made to the account minus any tax-free withdrawals you've taken. When figuring your cost basis, you group all of your IRAs of the same type together. This makes a Roth conversion appealing even if you expect to be subject to a lower tax rate when you draw down the account because you can avoid paying taxes on non-deductible contributions that you decide to convert to a Roth IRA.

Example of the benefits of converting non-deductible IRA contributions: You have a traditional IRA that includes 50% nondeductible contributions and 50% is from tax-deferred earnings/growth. If you convert the nondeductible contributions, that portion is not taxed when converted. The other half from growth is subject to taxation at the current marginal tax rate. But, from that point forward, every additional dollar of growth is tax-free inside the Roth. If you do not convert any amount, every additional dollar of return is subject to tax at the future ordinary income tax rate.

Backdoor Roth contributions

Investors with income above certain thresholds are ineligible to make direct Roth contributions. However, they are still able to make Roth contributions through a two-step process referred to as a “backdoor Roth.” With this method, they fund a nondeductible traditional IRA contribution and then convert to a Roth.

The backdoor strategy can be rather seamless for investors who have no other traditional IRAs. For investors who do have other traditional IRAs remember that the same type of accounts must be aggregated for the purpose of determining taxable conversion basis, even if only one of them is being converted.

Many investors who have traditional IRAs may avoid a Roth conversion and a backdoor Roth because of the potential conversion tax. This may be shortsighted if the person is young and will be able to keep the money in a Roth for decades and they invest the money with the potential to maximize growth. Also, each additional backdoor Roth contribution in future years further decreases the break even tax rate.
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Remember, the purpose of considering additional aspects of Roth conversions is to make as many future earnings and withdrawals escape taxation as legally possible, even if it means accelerating a current tax liability.

By paying taxes now and avoiding taxes on a larger balance later, investors may increase their net worth and have greater amounts of tax-free income in retirement.

Always consult with your CPA to determine your specific tax situation and how Roth conversions may affect you. CPAs and financial advisors should coordinate the Roth conversion plan for the client.